How to Protect Your Wealth From Inevitably Higher Taxes...
by Marc Courtenay
At a recent Investment U Conference, a ton of attendees confessed to me that higher taxes were among their chief concerns. And the last thing retired people need is a tax hike.
And considering that the federal government's deficit is expected to swell to over $1.5 trillion this year, tax increases are a foregone conclusion.
But like I pointed out at the conference, we don't have to be sitting ducks when it comes to protecting our money from the coming tax-rate changes.
We just need to be proactive and incorporate strategies designed to help reduce the potential negative impact of whatever tax changes come our way.
The "Get it Over With Now" Strategy
If you're like me, and expect your tax rate to be higher when you retire, consider an "after-tax" saving strategy. Such an approach allows you to grow your retirement funds with after-tax dollars. It also removes the uncertainty of where tax rates will be in the future when you decide to withdraw funds.
Contributions to a Roth IRA (if you meet the requirements) represent a great way to use this approach. You can also consider a Roth IRA conversion.
Or speak to your advisor about accelerating your withdrawals from your existing IRAs this year before rates go higher. Just be sure that withdrawing more from your IRAs doesn't put you in a higher tax bracket or create any negative "surprises."
For any of the "get it over with now" strategies, it's important to keep in mind that you probably won't have as many tax deductions in retirement. For example, many people pay off their home mortgages before they retire, which means they don't have the deduction of their mortgage interest to help offset their tax liabilities.
Remember, too, that unless your investment income comes strictly from tax-free investments (i.e. - municipal bonds), if tax rates go higher, you'll pay more taxes on the interest and dividends you receive from any taxable investments.
A Dose of Tax-Advantaged Securities
Another option to ward off the threat of higher taxes is to invest more heavily in tax-advantaged securities.
U.S. Treasury Series I Savings Bonds are one worthwhile option. They pay a rate of return that's set to the cost of living and inflation. And the return can be tax-deferred for many years.
You can also buy U.S. Treasury Inflations Protected Securities (TIPS), or an exchange-traded fund that invests primarily in TIPS, like the iShares Barclays TIPS Bond ETF (NYSE: TIP), which currently yields around 4%.
The income from TIPS is usually state income-tax exempt. In addition, the yield is linked to the rate of inflation, which means when inflation rises, so will your income.
Individual tax-free municipal bonds or funds that invest exclusively in such bonds... dividend-paying stocks held for at least 12 months... and exchange-traded funds (ETFs) specifically designed to limit your tax impact... are other good examples worth considering, too.
Two More "Tax Reducing" Tips...
To reduce our future tax burden, it's also important not to misuse our retirement accounts. By that, I mean certain investments are more suited for taxable accounts, while others make most sense in a tax-exempt or tax-advantaged account.
For instance, taxable accounts make more sense for investments we intend to hold for at least a year. That's because unrealized gains (capital appreciation) are not taxed and effectively offer the benefit of tax-deferred investing.
For short-term investments, taxable accounts are not the best option. Gains on securities held short term are taxed at higher ordinary income rates, which is why tax-deferred and tax-exempt accounts make sense for active traders.
As far as dividend investing goes, Roth IRAs are an attractive choice since interest and earnings are federal tax free, as long as certain requirements are met.
In the end, tax-smart investing is an ongoing process, requiring a regular review of your situation and long-term goals. And having an experienced tax advisor sure helps your investment cause.