Increase retirement income with smart tax moves

Stock chart, grey translucent calculator and blue pen.
iStockphoto Marlee90

(MoneyWatch) While you're collecting your tax and investment records for your tax return this year, it's a good idea to review your asset allocation and location strategies with respect to tax-advantaged accounts, including IRAs, 401(k)s, and after-tax investment accounts. You can decrease the taxes you pay on your investment returns with two strategic moves that can increase the amount of retirement income you can keep after paying federal and state income taxes. Here I'll describe the first move; stay tuned for my post tomorrow that describes the second move.

Shift from actively managed to index funds

If you invest in after-tax mutual funds, you've most likely got a good pile of Forms 1099-DIV. This form reports your total taxable dividends in box 1a, qualified dividends in box 1b and taxable capital gain distributions in box 2a. You might be confused by this last amount: If you didn't sell your mutual fund during 2011, why are you getting taxable capital gain distributions? The answer? Your mutual fund company sold securities during the past year at a gain, and the mutual fund is required to attribute a portion of these gains to your account.

This can happen if your fund actively trades securities in an attempt to beat their benchmark returns -- usually a futile task, as CBS MoneyWatch bloggers Allan Roth and Larry Swedroe have both reminded us. You might also get hit with capital gains distributions if your fund received a lot of redemption requests and needed to sell securities to raise cash.

Do you have substantial amounts of these reported realized capital gains from mutual funds that you held during the year? If so, not only are you getting hit with additional taxable income, to add insult to injury it's also likely that your fund is underperforming and you're getting dinged for investment management expenses that are far higher than those of index funds. If this is the case, it may be time to switch to low-cost index funds that don't generate much, if any, capital gains due to securities trading. Over the long run, these are likely to deliver higher net returns after taxes and investment management fees have been considered.

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By the way, if you decide to sell your mutual fund, the IRS will receive a report of this transaction on Form 1099-B. You may realize a taxable capital gain on the sale of your fund; this will happen whether you sell an actively managed fund or an index fund. Before you switch from an actively managed to a passive fund, you should check to see if you have any unrealized gains that will be converted to realized, taxable gains if you sell your fund. You should be able to see your unrealized gains if you have online access to your mutual fund accounts.

If this potential taxable gain is too high, the extra taxes you could pay might negate the potential gains from this maneuver. In this case, you might want to wait for a drop in the market, which is probably inevitable given the usual volatility. Sell on the dip to minimize your realized capital gains.

Stay tuned tomorrow for another tax move that can increase your retirement income.

Photo courtesy of iStockphoto contributor Marlee90.

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Retirement Game-Changers: Strategies for a Healthy, Financially Secure and Fulfilling Long Life and Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck.