The Bogleheads' Guide to Retirement Planning (26 page)

Taxes are often the biggest expense that investors pay. To help minimize the tax bite, you should view all of your investment accounts as one unified portfolio. A common problem investors face is how to efficiently invest a portfolio that is spread across tax-advantaged accounts such as an IRA or 401(k) and taxable accounts. It can be helpful to place the most tax-inefficient assets in your tax-advantaged accounts while holding the most tax-efficient investments in your taxable accounts. The advantage of placing assets in the right account is to defer paying taxes for as long as possible, while minimizing the taxes you do pay. The disadvantages are the increased complexity of rebalancing and the risk of actually increasing your taxes as the tax laws change.

Certain types of investments are, by their nature, more or less tax-efficient than others. Taxable bond funds tend to pay out interest at a higher rate than a stock fund pays dividends. More interest in a portfolio means more current tax liability, which makes taxable bond funds tax-inefficient for people in a high income tax bracket. Most stock dividends are taxed at a lower qualified dividend rate. So it makes sense to put stock funds in your taxable account and taxable bonds in your tax-advantaged account. Interest on municipal bond funds is tax-exempt, so they go in a taxable account. However, interest rates paid on municipal bonds are lower than on other bonds, so you pay a tax cost in lower returns rather than paying it directly to the IRS.

Table 9.2
lists various types of mutual funds in general order of tax-efficiency. Any fund in the Efficient category is fine in a taxable account. In the Moderate category, you should consider an alternative but not necessarily use one; in particular, if you have to hold bonds in a taxable account in order to meet your target allocation, you should hold them. Holding funds that are in the Inefficient category in a taxable account means you will pay higher income tax rates on distributions from those funds.

A fund that has a high turnover rate from frequent trading of securities in the fund typically has short-term capital gains, which are taxed at your ordinary income tax rate. There may also be long-term capital gains, but these are taxed at a lower capital gains rate. In contrast, a stock index fund or exchange-traded fund (ETF) may have no or very little capital gains distributions because the turnover in those funds is low. In the case of ETFs, the fund operations are such that fund managers are able to distribute low-cost basis stock to a third party, so rarely are gains distributed to shareholders. Gains in the value of ETF shares grow tax-deferred until you sell your shares.

Source:
Morningstar

Ideally, the preferred approach to overall portfolio tax management is to place the most tax-inefficient assets in tax-advantaged accounts while placing more tax-efficient investment in taxable accounts. As an example, most portfolios consisting of stock and bond funds are best allocated by placing bond funds in your tax-advantaged accounts and tax-efficient stock funds in your taxable account.

Tax location strategies are not always practical. When frequent contributions or withdrawals are being made to or from only the taxable account or only the tax-advantaged account, it complicates the strategy significantly. Asset allocations quickly become skewed to one asset class or another. Trying to balance between different taxable and tax-advantaged accounts can quickly become convoluted and frustrating. In that case, don’t try to tax-locate every asset class. Have the same stock and bond allocation in the taxable account as in the tax-advantaged account. That makes rebalancing easier. You could avoid using REITs and high-yield bonds in the taxable account because they are very tax-inefficient and perhaps substitute municipal bonds for taxable investment-grade bonds.

Your retirement plan should also take into consideration any noninvestment assets that will help provide for your retirement. These assets can provide income, decreasing the amount you’ll need from your own investments.

A pension provides the same amount of spending power throughout your retirement, so you will need less from your investments. Captain Susan Saver, who will receive a COLA military pension, uses the appropriate life cycle fund that takes this into consideration. A cost-of-living adjustment (COLA) is a benefit that is adjusted annually for the rate of inflation. Social Security payments have a COLA, and you will get annual increases in benefits as long as that system remains solvent.

If you have a pension that is not adjusted for inflation, the income will provide less spending power over time as inflation increases. One way to hedge a fixed pension is to invest in Treasury inflation-protected securities (TIPS) as part of your bond holdings. TIPS provide some ordinary income from interest and increase in value as inflation rises.

A home can provide additional money for your retirement. Assuming you have equity in your home, you could move to a smaller house or retire to an area where real estate prices are lower. Your home could provide a safety net in an emergency. You have the option of taking out a home equity loan against the equity or using a reverse mortgage to provide monthly income. If you own other real estate or a business, you will draw income from them during retirement and then eventually sell the assets and invest the proceeds in stock and bonds.

The key to successful retirement investing is developing a good investment plan, implementing that plan, and then following through on your commitment. Record your plan in an investment policy statement to document your progress. Your plan should include an adjustment of your asset allocation over time, similar to the glide path used in a life cycle fund. Keep your portfolio growing by making automatic contributions. If you invest in both taxable and tax-advantaged accounts, try to be tax-efficient by holding the least tax-friendly investments in your tax-advantaged account. You will be well on your way to a financially stress-free retirement after implementing these recommendations.

The time has come to pull all the knowledge and planning together and begin to implement your investment policy statement (IPS) to enable you to achieve your retirement goals. This is surprisingly easy, and in a few short steps you can be building a low-cost, tax-efficient, broadly diversified portfolio.

There are many different accounts that can be funded. Which one do you fund first? Which has the best return on dollar invested? Those are the questions this chapter sets out to answer. It is devoted to helping you make an informed decision from among the various types of accounts available to you. It also presents other strategies with the goal of turning every dollar you save while working into as many spendable dollars as possible for your retirement.

You have many different types of investment accounts to choose from. Several earlier chapters in this book covered taxable accounts and tax-advantaged accounts.
Table 10.1
summarizes the characteristics of various types of accounts used for retirement investing.

If you are eligible to contribute to an employer-sponsored retirement plan and your employer offers matching contributions, your first priority should be to contribute enough so that you claim the full amount of your employer’s matching contributions. When your employer offers you extra money without asking for anything in return, take the money!

Assume your employer matches 100 percent of your contributions to a 401(k) plan up to 3 percent of your salary. Then you should contribute a minimum of 3 percent of your salary to get the full match. Your contribution is tax-deductible and has the added advantage of lowering your income tax expense. By receiving the full match, you get an immediate 100 percent return on your investment. Even if the investment options in your employer’s plan are poor, make the minimum contribution to receive the maximum match. Never be dissuaded from taking free money.

Your employer’s matching contribution is not included as part of your taxable income, so you get no deduction for that. However, all funds in the account remain tax-deferred, whether you put the money in or your employer does. Only when you take money out do you become liable for income tax. You will be able retain the tax-deferred status even if you leave your employer or retire. When you separate from an employer, simply roll the account into an IRA rollover account with a broker or mutual fund company. IRA rollovers shelter your money from taxes until you are ready to start taking distributions.

Paying off high-interest debt is not retirement investing in the strictest sense, but it is your best return on investment. You should seriously consider reducing or eliminating high-interest debt as an integral part of your retirement savings plan. Paying off high-interest debt and revolving credit card balances offers the greatest risk-free, tax-free return on your money. By investing in high-interest debt repayment, you will earn an unbeatable guaranteed after-tax return on your investment, equal to the interest rate on the debt.

Reducing or eliminating high-interest debt also frees up cash flow for investing in the future. When the debt is gone, the payments can be redirected toward additional retirement contributions. There is also a psychological benefit: many people enjoy peace of mind from being free of high-interest or consumer debt. You may also find yourself spending less and living within your means, freeing up even more money to invest for retirement.

Tax-deductible retirement accounts are very powerful tools that can shield your earnings from relatively high marginal income tax rates while you are working and allow them to grow tax-deferred until they are withdrawn in retirement. Following retirement, the funds are likely to be taxed at lower income tax rates. The difference between the two tax rates can result in dramatic tax savings.

To understand just how powerful tax-deductible retirement accounts can be, you must first understand the progressive nature of the income tax code; the more you earn, the more income tax you pay (see Chapter 2 for complete details). That sounds obvious, right? Well, there’s more to it than that. As your income increases, not only do you pay more income taxes, but you pay an increasingly larger percentage of your income in taxes.

Different segments, or brackets, of your income are taxed at different income tax rates, and the rates increase as your income increases. Every additional dollar that you earn at the margin falls within your marginal tax bracket and is taxed at your marginal (highest) tax rate. By contributing to a tax-deductible retirement plan during your peak earning years, you avoid paying income tax on income that would otherwise be taxed at your marginal income tax rate. For example, if the top of your working income falls in the 28 percent marginal income tax bracket, and you contribute $1,000 to a tax-deductible retirement plan, your income tax will be reduced by $280. In other words, you can buy $1,000 in a tax-deductible retirement account for only $720. That’s a pretty good deal, and you should take it.