Why is Tax Efficiency Crucial to Retirement Savings and Income?
Let’s face it: nobody likes taxes, and no one (save for a few accounts) enjoys talking about taxes. The truth is that not paying attention to tax-efficient savings decisions might leave you with a smaller nest egg and cost you more in retirement. For some individuals, gaining a high investment rate of return is their top savings priority.
But did you know that being more mindful about the tax consequences of your savings and investing decisions could leave you with more money in retirement than focusing on investment returns alone? There’s no doubt that tax issues are complex, complicated, and sometimes a matter you’d rather avoid altogether. Even so, simple decisions like selecting the right savings plan and being selective with investment income might lead to potentially higher savings and more money to spend throughout retirement.
Decision 1: Saving in a Qualified vs. Taxable Account
Whether you’re a do-it-yourselfer or have worked with a financial professional, you likely know that contributing to a qualified investment account is a sure-fire way to build a retirement nest egg. So, what is a qualified account? These vehicles enable you to save for retirement and include employer plans like a 401k or 403b and individual retirement accounts (IRAs).
Qualified retirement accounts matter because they give you a sort of tax holiday, either allowing you to save for retirement before Uncle Sam gets a cut of your paycheck or providing you with an income tax benefit at the end of the year. Many people know these kinds of savings vehicles are a good thing, but how exactly might they help you from a tax perspective? To understand the potential tax benefit, let’s start by taking a look at the tradeoff between saving in an employer retirement plan versus a simple, taxable brokerage account.
Example: 401k and 403b Tax Savings
For illustrative purposes, let’s assume that you are married, earn $150,000 per year, and want to put away cash for retirement. Should you contribute to an employer retirement plan or invest your savings in a brokerage account? While money invested in either one of these accounts might produce a similar investment experience, contributions to the qualified account might provide you with more cash to invest from the start. How is this possible?
Well, contributions to employer retirement plans are considered above the line deductions. This adjustment means that the government gets its cut of your gross take-home pay after you’ve made a retirement contribution, allowing more money to go into retirement savings. So, for example, a $10,000 retirement contribution would leave you with take-home pay of $112,200 after accounting for taxes. And what if you decided to invest on an after-tax basis?
Put simply, not making the pre-tax contribution might leave you with less money to invest. That’s because your income is taxed at $150,000, rather than $140,000. While you may initially have a higher after-tax income of $119,800, you may only be left with $7,600 to invest if your goal is to maintain $112,200 in after-tax income. While this difference, $7,600 versus $10,000, may seem small now, every little bit of tax savings adds up over time.
To put the difference into perspective, assume that you have $100,000 saved, invest $7,600 per year and earn a return of 5.5%. At this rate, you could end up with a retirement savings of $556,000 after 20 years. How does this compare with contributing $10,000 to a qualified savings account? Applying the same assumptions, you could build a retirement nest egg of $640,000, which is $170,000 higher than investing on an after-tax basis. In this situation, contributing on a pre-tax basis, or before Uncle Sam gets a cut of your paycheck, lowers your income taxes, and allows you to save more money from the start.
Example: Traditional IRA Tax Savings
Now, if you’ve maxed out your 401k or 403b contributions, or otherwise are not able to participate in such a program, then investing in a traditional IRA may be another way to take advantage of favorable tax treatment. Whereas a 401k or 403b plans allow you to contribute to retirement savings on a pre-tax basis, an IRA uses after-tax dollars to fund your retirement savings.
Rather than providing an immediate tax benefit, the savings come at the end of the year when you file your taxes. As of this writing, the IRS allows individuals who have wage income to contribute $6,000 per year ($7,000 if over 50) in an IRA. Your IRA contributions might be eligible for an income tax deduction depending on your ability to participate in an employer retirement plan and household income levels.
In this case, while you may be able to contribute only $6,000 per year, this tax-deductible contribution may enable you to save over $1,400 on your tax bill. The simple takeaway here is that qualified accounts may empower you to accumulate more money, supercharge your retirement savings, and provide you with a tax benefit compared with saving in a simple brokerage account alone.
Decision 2: Being Selective with Retirement Income Investments
If you’re nearing retirement or are already retired, then sustainable retirement income will likely be a top priority for you. Stock dividends and bond interest payments are often two means for generating this much-needed income. Even so, not being aware of the tax consequences of income sources may leave you with less money in your pocket after the tax man comes calling. That’s why qualified dividends and tax-exempt interest are crucial to minimizing taxes when income generation is a retirement priority.
Before discussing qualified dividends and tax-free bonds, it’s crucial to understand how some investment income is taxed. For example, ordinary dividends and corporate bond interest income are typically subject to ordinary tax rates. This means that the income payments you receive from some of these securities would be taxed at the same rate as regular wages. On the other hand, qualified dividends are taxed at a rate lower than ordinary dividends, while tax-free bonds may be exempt from federal income taxes.
So, what distinguishes a qualified dividend from an ordinary dividend? Well, the IRS considers ordinary dividends to be regular income paid out by a corporation’s or mutual fund’s earnings and profits and thus subject to ordinary income tax rates. On the other hand, a qualified dividend is income received from 1) a U.S. corporation or qualified foreign corporation making the dividend payment and 2) subject to a specific holding period for the investment producing the dividend.
And what difference might it make to hold qualified versus ordinary dividends? Let’s look at an example. Two investment portfolios each have a value of $1,000,000 and receive a dividend yield of 2.5% per year. At this rate, each portfolio will generate interest income of $25,000 per year. Assuming that your effective tax rate is 24%, what might the difference be in taxes paid?
Because ordinary dividends are taxed as ordinary income, the $25,000 income you receive will generate a tax bill of $6,000. Qualified dividends, on the other hand, are currently taxed at a lower rate. Under the current tax regime, assuming a capital gains tax rate of 15%, you would owe the government $3,750 on $25,000 of income, saving you $2,250 per year on taxes. The point here is that simply taking the time to identify securities that offer qualified dividends can save you money over the long-term. And what about interest income?
Bond interest payments are another way to generate retirement income, but like ordinary dividends, these sources’ income might subject you to ordinary income tax rates. That’s why if you’re looking for a way to lower your tax burden and generate retirement income, tax-exempt bonds could help. This bond designation means that the interest payments you receive are generally tax-free at the federal level while some state taxes may apply. Even so, income from tax-exempt instruments, like municipal bonds, might provide you with higher after-tax retirement income.
So, what is a municipal bond? Well, municipal bonds, or Munis, differ from corporate bonds. They are often issued by a city, county, or state and used to pay for capital expenditures like roads, bridges, schools, and other infrastructure projects. Let’s look at an example of how Munis might save you money on taxes.
Let’s say that you invest $1,000,000 in a corporate bond that pays a 2% coupon per year. Carrying forward some of the assumptions we used earlier, income received on this bond would be subject to tax at an ordinary effective income rate of 24%. So out of the $20,000 interest income you receive, $4,800 would go to paying the IRS, leaving you with $15,200 on an after-tax basis.
Because of their tax-exempt status, a municipal bond offering the same sort of coupon rate might provide you with $20,000 income, which is nearly $5,000 more than the taxable bond when we ignore state and local taxes. Now, in practice, you’re likely to find that yields on Munis are lower than those of taxable bonds and mainly reflects the tax advantage of Munis.
Even so, a key benefit of income derived from qualified dividends and interest income from municipal bonds is that their income does not affect your overall adjusted gross income. This can be particularly helpful during tax season if you’re drawing retirement income from multiple sources and are looking for ways to stay in a lower overall income tax bracket. Either way, being mindful of your income source’s tax implications can help you save more money and make your savings go further in retirement.
Become Tax-Efficient with Your Retirement Savings and Income
Let’s face it: nobody likes taxes, and most people don’t enjoy talking about taxes. The truth is that not paying attention to tax-efficient savings decisions might leave you with a smaller nest egg and cost you more in retirement. There’s no doubt that taxes are complex, complicated, and sometimes a matter you’d rather avoid altogether. Even so, simple decisions like selecting the right savings plan and being selective with investment income might lead to potentially higher savings and more money to spend throughout retirement.
Read More Recent Posts
- Another Recession is Here. Now What?
- Three Things You Can Do About Inflation
- Is now the right time to get into the markets?
- Are Your Financial Goals Meaningless?
- Is it Possible: Two Recessions in Two Years?
- Worried About Ukraine and Your Money? Consider these Six Things.
- Russia Invades Ukraine – What Now?
- Don’t Call it a Crash (Yet)
- Crush Your Financial Resolutions by Becoming Rather than Doing
- What to Make of the Black Friday Market Selloff?