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Lower Your Taxes In Retirement

As April 15 approaches, MoneyWatch is publishing daily tax tips. Please check back frequently for the latest advice from our experts.
One important tax planning strategy for retirees is something called asset positioning. That basically means figuring out what investments to place in which accounts so that you're paying the lowest tax possible.

We're going to assume that you're like many retired investors, and you have some of your retirement money in your IRA rollover accounts and some money invested in a joint or individual brokerage account.

  • As you know, the money in your IRA is not subject to tax until you actually take a distribution.
  • The money in your brokerage account, however, is subject to tax each year. That means if you receive interest, dividends or have capital gains, you must pay tax on those funds even if you don't intend to spend any of that money.
Let's also assume that like many retired investors you have some money in stocks and some money in bonds, CDs, or other types of interest bearing investments. So should you put the stocks or bonds in the IRA or brokerage account, or should you put some of each in both accounts?

For most investors, you'll probably pay a lower total tax bill if you allocate the stocks to the brokerage account and the bonds to the IRA. Here's why:

In general, qualified stock dividends and long-term capital gains are currently taxed at 15%.

Distributions from IRAs, however, are subject to ordinary income tax rates which go up as your income rises. For joint income tax filers, the rates start at 10% on your first $16,750 of income, jump to 25% once you reach $68,000, hit 28% for amounts over $137,300, and continue up to 35% at $373,650.

To illustrate how asset positioning can help, I'm going to go through a simplified example of the tax figures:

  • Let's assume that for the year you'll have Social Security income of $25,000 and investment distributions of $75,000, for a total income of $100,000.
  • Your Social Security income is going to fill up the first $16,750 of income, which will be taxed at 10%. Now for any income you earn between $16,750 and $68,000, you'll be in the 15% income tax bracket. Since your Social Security is $25,000, that means means you've got about $43,000 of income you can still squeeze into that 15% bracket.
  • Let's assume you take that $43,000 from your IRA. This money is treated as ordinary income, and is subject to the 15% bracket.
  • Since you want to take a total investment distribution for the year of $75,000, you've still got another $32,000 to go. Where should you take that money from?
If you continue to take it from the IRA, the distribution will push you into the 25% bracket for that additional $32,000. But, if you can take it from some combination of stock dividends and capital gains in the brokerage account, you'll only pay 15% on those funds.

By properly positioning your assets, you've lowered your total tax bill, and increased the amount of money you have for spending.

Depending on how your savings are distributed, some people can get all of their stock holdings in their brokerage accounts and their bonds in their IRAs. But it doesn't always work out so neatly. The basic point, however, is to pay attention to where you have placed your assets, and attempt to get as many of the equity type holdings into accounts that will allow you to benefit from the current 15% dividends and capital gains tax rates. The bonds can go in the IRA because the bond interest is subject to ordinary income tax rates, which means its tax status isn't changed by being in the IRA.

The tax favored status for dividends and capital gains was part of the tax cuts implemented by President Bush. But the lower rates are scheduled to expire at the end of this year. The current proposal from the Obama administration appears to be to allow the rates for dividends and capital gains to climb to 20% for taxpayers making more than about $250,000, and retain the lower rates for those making less.

It's difficult to determine how the tax battle will shake out. But it looks like capital gains and dividends will still retain their lower tax status when compared to ordinary income tax rates. If, however, Congress does nothing, then long-term capital gains goes to 20% and dividends are taxed as ordinary income again in 2011.

  • If you're worried about taxes eating up more of your retirement income, make sure you pay attention to how your elected representatives plan to vote on any changes to the dividend and capital gains tax rates. If you don't want your taxes to go up, consider letting them know.
Bottom line. Asset positioning can help you save taxes in retirement. To the extent possible, make sure that you preserve the tax favored status of qualified dividends and long-term capital gains.

Consult your tax advisor prior to making any tax decisions; individual circumstances will vary.
More Tax Tips:
Beware Estate Tax Surprise
Don't Rush Into Roth Conversions
Stop Freaking Out About Taxes
Tax Loss Harvesting
Make $500 An Hour Doing Taxes
Master Limited Partnerships Have Tax Advantages
Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.

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