Tax season comes with an abundance of information to keep track of for both clients and advisors. While it can feel like a chore, it’s an important time of the year to look at ways to minimize the tax impact on your investments to strengthen your path to a secure retirement.
Many investors make the mistake of spending too much time chasing higher returns and not thinking about what is going on tax-wise in their portfolios. The result can be a portfolio that seems fine on the surface but isn’t compounding returns as efficiently when the impact of capital gains and income taxes are accounted for. Here are some things to consider to help you can become a more tax-savvy investor.
Choose the right accounts. This means maximizing the tax advantages found in your employer’s retirement plan and in contributing to a Roth or traditional IRA account. This is important because these accounts compound returns without being subject to any income or capital gains taxes until you’re ready to take distributions from them when you retire. The longer your time horizon until retirement, the more advantageous this strategy becomes.
Also, make sure to contribute enough to your employer’s retirement plan to get the full matching contribution, as this is free money that will grow for you over time. By increasing contribution limits for 2024, Secure Act 2.0 gives both employees and business owners the opportunity to have more money growing in their retirement accounts on a tax-deferred basis.
Contribution limits are now $23,000 for employer retirement plans, $7,000 for individual IRAs and the lesser of $69,000 or their annual salary for business owners who sponsor a plan. When catch-up contributions for those over age 50 are added in, the limits increase to $30,500 for retirement plan participants, $8,000 for IRAs and the lesser of $76,500 or their salary for business owners.
Consider a Roth IRA. Roth IRA ac counts are important to consider when thinking about minimizing taxes since there is no tax on distributions in retirement and no required minimum distributions, but these valuable benefits come with some considerations.
First, Roth IRAs are funded with after-tax dollars, whereas traditional IRAs or 401(K) plans are funded with pre-tax dollars which reduce your taxable earnings. Second, there are income requirements that prohibit individuals earning more than $161,000 and married couples earning more than $240,000 from making contributions. However, a Roth conversion allows a work-around to the income limits so that traditional IRA assets can be converted into Roth assets. The downside is that the converted assets are treated as taxable income for the year in which the conversion occurs, but it may make sense in situations where income is lower in a particular year or you have funds available to pay the additional tax burden. The bottom line is that Roth IRAs can be an excellent vehicle, but it is important to first consult with your tax advisor to ensure that it is appropriate for your situation.
Be efficient with your assets. Once you have maximized the tax benefits of investing in retirement plans, you will need to look at ways to be more efficient with assets you accumulate that are not held in tax advantaged accounts. Investors should know where they stand within their tax brackets and develop strategies in concert with their tax and financial advisors to minimize tax impact.
For income-oriented investors, this may involve mixing in some tax-exempt municipal bonds so taxable interest doesn’t push them into a higher bracket.
On the equity side, it is important to take a long-term perspective by investing in quality assets that can have longer holding periods. This will allow you to have more control over the amount and timing of capital gains that are realized within the portfolio.
There are a variety of investment vehicles that can be used to accomplish this, such as exchange traded funds (ETFs), index funds, a diversified portfolio of individual stocks or a tax-managed mutual fund. Exchange traded funds are worth considering as they have lower expense ratios, more liquidity, and disperse a minimal amount of capital gains when compared to actively managed mutual funds.
As markets have grown more efficient through the years, your asset allocation strategy is more important in determining performance than specific investments. That is why, on the path to securing your retirement income, investors should work closely with their advisors to focus on both investment expenses and tax impact to maximize value in their portfolios.
This material has been prepared for informational purposes only and is not intended to be relied on for tax advice. Consult a tax professional before engaging in any transaction.
Charlie Mathews is senior wealth management consultant for NBT Wealth Management.
Many investors make the mistake of spending too much time chasing higher returns and not thinking about what is going on tax-wise in their portfolios.
