How to Use the Tax Code to Retire in Style

This article is original content written by Manchester, CT Financial Advisor Thomas Scanlon, CFP®, CPA

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How do you envision your retirement?  Spending long, lazy days at the beach? Spending more time with your grandchildren? Going golfing or fishing a lot more?  Everyone has their own ideal retirement plan.  Want more help getting to your retirement?  Use the tax code.  The tax code provides plenty of incentives to help you retire in style.   Here are some things to consider:

Retirement Plans

Many employers have terminated their pension plan. Now it appears that only federal, state and municipal employees will get a pension when they retire.  Many businesses have instead adopted a 401(k) plan. This plan allows employees to contribute up to $19,000 pre-tax annually. Employees age 50 and older can make a so-called ‘catch-up’ contribution of an additional $6,000 for a total of $25,000.   Many employers will offer an employer match. Employees need to enroll in the 401(k) and contribute at least the amount needed to be eligible to get the match.  401(k) plans, like IRA’s offer tax deferred investing.

Make contributions to the 401(k) plan without currently being taxed on it.  When you retire and start taking distributions from the 401(k) plan these will be taxed as ordinary income.  The idea is that for most folks they are in a higher income tax bracket when they are working. When they retire they are expecting to be in a lower income tax bracket.

Some employers may offer a Roth 401(k) plan.  With this plan the contributions are not put in pre-tax.  Contributions are put in after tax.  The benefit to a Roth 401(k) plan however is that when distributions are made, they are tax-free.

Younger employees should consider making their contributions to the Roth 401(k) plan.  Decades of tax-free growth in their Roth 401(k) plan will go a long way to setting them up with a nice retirement.

If the employer offers a match however, this must be done in the traditional 401(k) plan mode.  Distributions of the employer match from a Roth 401(k) plan would be taxed as ordinary income.

IRA’s and Roth IRA’s

Many people can also fund an Individual Retirement Arrangement (“IRA”). Eligible taxpayers can contribute up to $6,000 per year.  Taxpayers age 50 and older can contribute an additional $1,000 of a ‘catch up’ contribution for a total of $7,000.  To be eligible for an IRA you will need to have earned income.  This is from wages working as an employee or perhaps being self-employed.  Taxpayers can contribute to an IRA up to age 70.

Upper income taxpayers can’t make tax deductible contributions to an IRA.  They can still open and fund an IRA, they just won’t be entitled to an income tax deduction.  These IRA’s are known as non-deductible IRA’s. For a married couple filing a joint return if neither of them is not covered by a retirement plan at work they can both fund and deduct their IRA.  If a married couple filing a joint return and one spouse is covered by a retirement plan at work there is an income limit for them to make a tax deductible IRA. For this couple if their Modified Adjusted Gross Income (“MAGI”) is under $196,000 they can still make tax deductible IRA’s.  If their MAGI is over $196,000 and less than $205,999 they can make a partially deductible IRA.  If their MAGI is over $205,999 they can’t make a tax deductible IRA contribution.

Another option for investors is the Roth IRA.  Like the regular or traditional IRA mentioned above the contribution limits are the same $6,000 and $7,000 if you are age 50 and older.  Keep in mind, this is the maximum amount you can contribute annually to either an IRA or a Roth IRA or some combination of the two.

Another advantage to the Roth IRA is that there is no age limit as to when you can stop contributing. As long as you have earned income and your income stays below the threshold, you can continue to contribute to your Roth IRA.

Like the IRA, the Roth IRA has income limits. The limits are the same for the IRA. Unlike an IRA, you are not allowed a tax deduction with a Roth IRA.  Roth IRA contributions are made with after tax dollars.  The benefit with a Roth IRA however is that if the distributions are qualified, then all of the distributions are tax-free.  Not tax deferred like an IRA, tax-free. Again, younger investors should consider a Roth IRA.  Younger investors are generally in a more modest income tax bracket. Funding the Roth IRA at an early age will also make a huge impact on their retirement.

To have your Roth IRA distributions be qualified there is only two simple requirements.  First the Roth IRA account needs to be open for at least five years.  Second, you can’t take distributions until after age 59 1/2. That’s it, meet these two simple requirements and all of the distributions are tax-free. There is another advantage with the Roth IRA.  Regular IRA’s are subject to the Required Minimum Distribution Rules (“RMD”). These rules require taxpayers to begin taking distributions from their IRA’s and 401(k)’s after they turn 70 1/2. The IRS has tables that essentially require taxpayers to take these funds out over their life expectancy. With the Roth IRA there is no RMD requirement during the owners or surviving spouse’s lifetime. This allows the funds to continue to grow tax free. Non-spousal beneficiaries like children and grandchildren will have the RMD requirement.  However, if the distributions are qualified, they will also be tax-free. If you don’t need the funds in your Roth IRA, it becomes a great wealth transfer tool.  Fund the Roth IRA during your lifetime and leave it to your children or grandchildren when you pass away.

There is another advantage with the Roth IRA.  You can take out your contributions at any time income tax free and no penalty.  Your contributions must come out first.  So while the objective of a Roth IRA is to save for retirement, this allows investors that need funds to have access to their Roth IRA contributions if needed.

Tax Advantaged Investing

Certain investments offer tax incentives.  Capital gains tax is perhaps the one most discussed. Investing in stocks or bonds are examples of capital assets that may receive preferential tax treatment.  Stocks or bonds that are sold at a gain with a holding period of a year of less are known as short term capital gains and are taxed as ordinary income.  Federal income tax rates start out at 10% and go up to 39.6%.  Long term capital gains apply to capital assets that are held long term. This means holding the capital asset for more than a year.  For most investors their long term capital gains tax rate will be 15%. There are however different rates for lower and higher income taxpayers. For taxpayers in the 10% or 15% ordinary income tax bracket, their capital gains tax rate is 0%.  For taxpayers in the 39.6% ordinary income tax bracket their capital gains tax rate is 20%.  Clearly the long term capital gains tax rate is preferred.  As with all investments however, don’t let the tax tail wag the dog.

Another tax advantaged investment is municipal bonds.  These are bonds that are issued by state, county and local municipalities.  The interest received on these bonds is not subject to federal income tax. If the bond is issued from the state that you are a resident of then it is also exempt from state income tax.  For example, a Connecticut Resident buys a municipal bond issued by the State of Connecticut would be federally and state tax free.  This is known as double tax free. Higher income earners benefit the most from investing in municipal bonds.

High income earners however also need to be concerned with the Net Investment Income Tax (“NIIT”).  This tax is assessed against married couples filing a joint return with Modified Adjusted Gross Income over $250,000.  The rate is 3.9% and it applies to interest, dividends, capital gains, and rental and royalty income.

Tax Deductions

Taxpayers are allowed to deduct the higher of their itemized deductions or the standard deduction.  The standard deduction for a married couple filling a joint return in 2015 is $12,600. This number is indexed to inflation and increases slightly each year.  The most common itemized deductions are interest, taxes, and charitable donations. Homeowners are allowed to deduct the mortgage interest on their residence up to $1 million in mortgage plus $100,000 line of credit. If you own a home you will also be able to deduct your real estate taxes as an itemized deduction. Also, you will be allowed to deduct any state income tax paid as an itemized deduction.

Certainly you don’t want to buy the biggest house you can afford and put the maximum mortgage on it just because you are ‘qualified.’  Historically low interest rates have enticed many people buying a home to borrow as much as they can. The purchase of a home and putting a mortgage on your property is a big commitment.  The price of your home and the amount of mortgage needs to be made in the context of your overall financial plan.

There is another tax advantage when you sell your primary residence.  A married couple can exclude up to $500,000 of gain and a single person can exclude up to $250,000 of gain from the sale of their primary residence. The gain is calculated by subtracting the cost basis from the sale price. The cost basis is the amount paid for the home plus the major improvements made.  Additionally, the expenses of sale including the realtors’ commission is added to the cost basis.

Many of the people we work with are very generous and make charitable donations.  Many will make cash donations to their favorite charity. These donations are also allowed as an itemized deduction.  Some folks however will give appreciated stock to their favorite charity.  For example, they own 100 shares of a stock that they paid $50 a share and want to donate it to the local hospital.  They will receive a charitable donation for the fair market value of their stock on the day they donate it.  This is a gift of so-called appreciated property.  They paid $50 per share and now it is worth about $100 per share. If they had sold the stock and then donated the proceeds, they would have had to pay capital gains tax on this sale. By making the donation of the stock directly to the charity they don’t have any capital gains tax to pay and they get a charitable deduction for the fair market value of the stock.

Most donations of cash or check are limited to 50% of Adjusted Gross Income (“AGI”). When giving appreciated property however, the limit is lower.  Gifts of appreciated property are limited to 30% of AGI.  The good news is that donations of appreciated property made in excess of this can be carried over for five years.

Please notes, changes in tax laws may occur at any time and could have a substantial impact upon each person’s situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.  There are risks associated with an investment in a municipal bond, including credit risk, interest rate risk, prepayment and extension risk, and geographic concentration risk. Interest from municipal bonds may be subject to or exempt from federal income tax.  Bonds with exempt interest may be subject to the federal alternative minimum tax, or state or local taxes.  Bonds may incur capital gains taxes if sold or redeemed at a profit.