A Tax Tip for Boosting Your Retirement Income

Steve Vernon
March 28, 2012

Yesterday I advised reviewing your asset allocation and location strategies as a way to minimize your income taxes and increase net returns. Now here's another tax tip for boosting your retirement income.

Equity investments in after-tax accounts are eligible for the reduced federal income tax rate of 15 percent that applies to realized long-term capital gains and qualified dividend payments. To be eligible for long-term capital gain treatment, you'll need to hold your investments for more than one year. (Note that equity investments in tax-advantaged accounts, such as IRAs and 401(k) accounts, aren't eligible for this special tax treatment. Any amount removed from a traditional IRA or 401(k) is subject to ordinary income taxes upon withdrawal.)

Bonds and cash investments are also taxed at ordinary income tax rates in after-tax accounts (unless they're municipal bonds). In traditional IRA and 401(k) accounts, the principal and income from bond and cash investments are taxed at ordinary income tax rates when withdrawn.

If you have both tax-advantaged accounts and after-tax investments, you'll most likely pay less income tax over your lifetime if your after-tax accounts hold the stock investments that will receive the reduced federal income tax rate on capital gains and qualified dividends. Use your IRAs and 401(k) accounts to hold your bond and cash investments, since they don't receive any special tax treatment when held outside a tax-advantaged account.

It's a good time to review your Forms 1099-INT to see if during 2011 you had substantial amounts of taxable ordinary income due to interest on bond and cash investments. Also examine your IRA and 401(k) statements to see if you're holding substantial equity investments.

While there can be good reasons to hold stocks in your IRA or 401(k) account to profit from long-term growth, many people make the mistake of allocating the investments in these accounts without considering their other after-tax investments. A better approach is to make your asset allocation decisions taking into account both your tax-advantaged accounts and after-tax investments. Holding stock investments in after-tax accounts and bond investments in tax-advantaged accounts might reduce your income taxes.

This strategy has another advantage: It can help minimize the required minimum distributions (RMD) you'll need to make from your traditional IRA and 401(k) accounts beginning at age 70-1/2. Let's see how this can work.

The usual investment theory is that you hold stocks for growth and bonds for income and safety. So you'd expect your stock investments to grow faster than your bond investments (though this doesn't always happen). If you hold your faster-growing investments -- stocks -- outside your IRA and 401(k) accounts, these are free to grow without worrying about the RMD. By keeping your slower-growing investments -- bonds and cash -- inside tax-advantaged accounts, you'll reduce how much of your total retirement savings are subject to the RMD.

As with the strategy I described yesterday, proceed carefully. Look at your unrealized gains in the after-tax funds you have that hold bonds; given the recent decline in interest rates, it's possible you might generate taxable capital gains on the sale of the funds that hold bonds.

Be cautious: The reduced tax rate on capital gains and dividend income might be revisited after the upcoming election, as part of a congressional effort to simplify the tax code (in your dreams!). In theory, though, whether these tax rates change likely depends on who wins the presidential election and which party controls Congress.

As long as you're spending time prepping for your tax returns, take a little extra time to review your investments --  think about how you can redeploy your tax-advantaged and after-tax investment accounts. You might be able to decrease your income taxes, increasing your retirement savings. And who can argue with that?