The relationship between investments and taxes is perhaps one of the most overlooked areas of retirement planning. Decisions that are made on the investment side of your retirement plan will most likely have some type of impact on your tax return.
In the video below, BFG Tax Service’s JoAnn Huber, CPA, CFP®, and Partner with Barber Financial Group, explains the difference between tax planning and just filing your taxes and why it’s important to look at the whole financial picture with taxes.
Typically an investor will have three different tax buckets that they can place money into. They will have the tax-deferred bucket, the tax-free bucket, and the taxable bucket.
First, we will address the tax-deferred bucket.
The tax-deferred bucket can be made up of qualified retirement plans such as 401(k)s, 403 B’s, 457 plans, IRAs, TSPs, etc. In these plans, you will typically receive an immediate deduction on your taxable income when making a contribution. Any gains in the account grow on a tax-deferred basis. Taxes are only done on these accounts when distributions are made. Many rules surround the distributions of retirement plans.
Qualified retirement plans carry a 10% penalty for early withdrawal before age 59 ½ unless certain qualifications apply. These qualifications could be death, divorce, first-time home purchase or a series of substantially equal payments under IRS code section 72T. Qualified retirement plans will also carry something called a required minimum distribution which occurs in the year the taxpayer turns age 70 ½. At this point, you are required to make distribution even if you don’t need the money.
Many people make the mistake of not having proper tax diversification and having too much money in their qualified retirement plans. This can become very burdensome once you have reached age 70 ½ and required minimum distributions start. There can be a domino effect causing capital gains that were otherwise tax-free to become taxable. It can also create additional Social Security income to become taxable. If income limits are high enough it can also cause an increase in Medicare taxes. When investing in a tax-deferred account, it’s essential that you understand when you’re going to take the money out and have some understanding of what your tax bracket will look like during that distribution phase.
Now let’s take a look at the tax-free bucket.
The tax-free bucket is very limited in scope. If you’re looking for true investments, you will be limited to a Roth IRA or municipal bonds. The Roth IRA, unlike the traditional IRA, will accumulate and distribute money tax-free. Keep in mind you must hold the Roth IRA for at least five years and until you’ve attained the age of 59 ½ to get the tax-free treatment. Many other additional rules follow the Roth IRA, but suffice it to say this is probably one of the best tax codes that you can put investments in. Municipal bonds are loans to municipalities where the interest comes federally tax-free, and if the bond is held in the state in which you live, they are also state tax-free. Any capital gains arising from the sale of a municipal bond will be taxable depending upon the tax bracket the investor falls in.
Lastly, you have your taxable bucket.
The taxable bucket can be jointly titled assets in savings, checking, CDs, money markets, brokerage accounts, mutual funds, exchange-traded funds, or just about any investment that you can think of that is held either in an individual name in the name of a trust or jointly with rights of survivorship. Capital gains and qualified dividends have a different tax rate than the ordinary income tax rate. Over the years this has been a moving target. As of the date of this writing, as long as the taxpayer stays in the 15% tax bracket or lower, capital gains and qualified dividends are tax-free.
If the taxpayer goes into the 25% tax bracket, then capital gains will be taxed at 15%. When looking at dividends and capital gains in retirement, it’s important to keep in mind that even though the dividends and capital gains may not be taxable due to your current tax bracket, they can cause additional Social Security to become taxable. This could end up pushing you into that next tax bracket and potentially cause the capital gains and dividends to become taxable.
It is critical that all tax considerations are clearly understood before investing. That’s not to say that you should only invest to reduce taxes but to clearly understand any tax consequences as this is effectively a reduction in your rate of return.
If you have questions about your taxes and how it relates to your overall retirement plan, or need assistance in the preparation of your 2018 tax return (even if you aren’t a client of Barber Financial Group!) call our office today at 913-393-1000 or fill out the form below to make your appointment.
Investment advisory services offered through Barber Financial Group, Inc., an SEC Registered Investment Adviser.
The views expressed represent the opinion of Barber Financial Group an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Barber Financial Group does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.