Which retirement account, vehicle or venture is best? One thing is certain, diversity still carries the day when it comes to investments as different ones afford the most flexibility. The returns on different types of investments are treated differently by the tax code, which logically means that some get better tax treatment than others. Qualified dividends and capital gains, for example, are taxed at a lower rate than ordinary income, and thus are attractive investment options for retirement.
*Roth and Traditional IRAs
The Roth option requires that contributions go in after tax, allowing earnings to come out free of tax in retirement. Contributions to a traditional IRA may be tax-deductible in the year in which they are made but taxes will be due when mandatory withdrawals begin at age 70 1/2. The tax-free income from a Roth account can help retirees control the amount of taxes they pay on Social Security benefits.
*Municipal Bonds
The interest paid on bonds is generally taxed as income, except when the IRS says it’s not, such as in the case of municipal bonds. Most municipal bonds are tax-exempt at the federal level, giving investors tax-free income.
*Low Turnover funds and ETFs
“Tax-efficient investments like low turnover funds and exchange-rated funds, or ETFs as they are much more commonly known, have low turnover and low capital gains. Turnover is the frequency of trading that managers do within the fund. As Mike Patton, the President of Integrity Wealth Management opined, “the structural difference and potential absence of long-term capital gains in ETFs makes them a compelling investment vehicle.” This gives them an advantage over mutual funds in situations where long-term capital gains are much more likely to occur.
*MLPs & REITs
Though complex for the average investor, taxpayer future retirees may benefit from master limited partnerships, or MLPs, and real estate investment trusts, also known as REITs. MLPS have a high and potentially fast-growing yield. MLPs are pass-through entities, meaning they don’t pay taxes on earnings provided the great majority of them are passed on as distributions to participants. Typically 80% to 90% of the distribution is in the form of return of capital. Since this income generated by a MLP is a return of capital, it is not taxable. Instead the return of capital, or ROC, lowers basis and, when it reaches zero, results in most of the ROC being taxed as long-term capital gains, taxed at lower than regular income tax rates.
REITs potentially offer income as well as tax savings. Dividends from REITs are taxed as ordinary income; dividends in excess of the REIT’s taxable income are treated as a return of capital. As with MLPs, the return of capital reduces the investor’s cost basis. Certain REIT sponsors provide tax-free earnings to investors due to their use of accelerated depreciation on the properties held in the REIT. At the end of the year, unit holders receive a 1099 with the amount of income which is taxable. An investor may receive thousands of dollars of income, none of it taxable because of depreciation.
*Life Insurance and Annuities
Though life insurance won’t help the deceased during his or her lifetime, it will help a policyholder’s heirs. Life insurance can also distribute tax-free streams of income up to what a policyholder invests in the policy to complement other retirement streams of income. Of course, pulling cash from a life insurance policy reduces the death benefit. Annuities are a type of insurance product that manages an individual’s longevity risk and utilizes an exclusion ratio. This means that part of the income from the investment will be taxable according to the exclusion ratio.
If you are planning for retirement and have a question or concern about investment opportunities and their tax consequences, call THE TAX EXPERTS at the Thorgood Law Firm www.thorgoodlaw.com. For a FREE consultation call 212-490-0704.
