Income tax rates are going up, although maybe not as soon as we expected. Until the economy begins a sustained recovery, the political will to tax our way out of extreme deficits may be lacking. Nevertheless, strategic tax-planning should always be on your retirement investing agenda. If you can save 5% in taxes, that’s not chump change when you retire.
The first step, of course, is to max out contributions to your tax-deferred retirement accounts, e.g. 401(k), 403(b), and IRA. If you are lucky enough to have money left over to invest in a taxable account, here are some suggestions:
1. Own tax-free and/or tax-deferred investments. Your options here are somewhat limited and include municipal bonds and muni bond funds (tax-free) and I Bonds (tax-deferred).
2. Own individual stocks and exchange-traded funds (ETF). Conventional mutual funds can generate taxable income through dividend and capital gains distributions. This can occur even if the NAV of the fund has not increased over the year and even if you choose to reinvest the distributions. Individual stocks may produce dividend income but they will not trigger a capital gain unless and until you sell. An ETF is far less likely to make a capital gain distribution.
3. Own index funds not managed funds. The “geniuses” who manage funds are inclined to do a lot more buying and selling of investments inside the fund compared to a fund that merely tracks an index. These transactions tend to generate more taxable distributions for fund owners.
4. Offset gains with losses. As you get closer to retirement, re-balancing and re-allocating of assets in your taxable portfolio may be necessary to reduce risk. Look for opportunities to do this in a way that allows you to sell losers so as to offset taxable income generated in your other investments. Then pull the trigger to save you tax dollars. Capital losses can be used to offset all capital gains. Up to $3,000 in capital losses can even be used to offset taxable income that is not a capital gain.
As we approach the last quarter of the year, start thinking about whether any of these strategies can decrease your tax liabilities.
Does anyone have other suggestions to share?