Retirement: Tax Breaks Worried Investors Ignore
Life + Money

Retirement: Tax Breaks Worried Investors Ignore

iStockphoto/The Fiscal Times

If you were eligible for a big tax break that would keep more money in your pocket, would you pass it up?

Of course not.

But many retirement investors are essentially doing that: They are ignoring tax strategies that, if pursued, could save them a bundle over the long term and make their nest eggs last much longer than they originally assumed.

A recently released three-year study by the 401(k) advisory firm Financial Engines concluded that fears about wild stock market volatility and the economy in general have caused an overwhelming paralysis among investors nearing or in retirement. “Given how high the stakes are in retirement, people don’t feel equipped to make any investment decisions, and they freeze,” says David Ramirez, a senior portfolio manager at Financial Engines and an author of the study.

Even in better times, many people investing for retirement treat tax planning as an afterthought, preferring to obsess about how best to allocate their assets between stocks, bonds, and real estate.  But now, as investors gape in shock and horror at the stock market’s daily gyrations, they ought to be thinking about clever tax strategies to help them soften the blow of brutal market swings.
Tax and investment advisors have a message for these folks: Snap out of it. The tax code can be your ally in these tough financial times.

“It’s true that we can’t control the markets, but investors should be focusing on the things they can control about their investments – and a big one of those is tax efficiency,” says Matt McGrath, an investment advisor in Coral Gables, Fla., referring to techniques to assure a top after-tax return.

Here are three of the biggest commonly overlooked tax maneuvers that can guarantee to improve your portfolio’s overall performance.

  • Make use of your losses. Instead of weeping over your brokerage statements, consider the latest stock market decline as an opportunity to realize losses to offset gains, possibly for years to come.

    Remember the rule: You can use long-term losses to offset long-term gains, and short term losses to cancel short term gains. Any unused losses can offset up to $3,000 in income. If you still have excess losses after that, they can be rolled over and used in subsequent years.

    Don’t ever think you’ve locked in enough losses – once the market goes up, you’ll use them up faster than you think. “In any decline, at some point investors say, ‘Wow, that’s enough losses,’ but even losses in 2008 were worked off by 2010,” says Christopher Cordaro, an investment advisor at RegentAtlantic in Morristown, N.J.

    In order to write off a loss from the sale of a stock or investment, you have to wait 30 days to reinvest in that company or enterprise. But you can sell, immediately invest in a similar fund or stock, and then buy back your original favorite. This way you won’t miss out if the market bounces back up.

  • Size up your mutual fund by its after-tax returns -- you may be surprised at what you find. The upside to getting less in capital gains distributions is not having to pay a lot of tax on fund distributions.  Taxable distributions can seriously erode your gain, by many “basis points” or fractions of a percent.

    “Investor typically don’t realize how many basis points of their returns can be shaved off because of tax inefficiencies,” says Davinder Malhotra, professor of finance at Philadelphia University, who recently completed a study that found funds with the highest expenses also have the biggest gaps between their pre- and after-tax returns.

    On average, mutual fund investors lose about 1.8 percentage points a year of their value to taxes, says Joel Dickson, the Vanguard Group’s senior investment strategist. In rising markets, the average tax hit rises to about 2.5%. Funds rack up a tax bill as their investments generate dividends and managers actively sell securities to lock in gains.

    “Mutual fund managers are used to managing without paying attention to taxes—it’s their gross returns that will be in the big advertisement in the newspaper,” Cordaro says.

    An exception is funds that promote themselves as being tax efficient. Managers of these portfolios take great pains to trade less frequently and, when they do, to pay close attention to which shares they are selling to have the least tax impact. A manager may buy shares continually, or in fits and starts, so when it’s time to sell some shares, a manager can carefully choose a specific batch of shares that has the most optimal cost basis and holding period to minimize tax consequences.

    Index funds and exchange-traded funds (ETFs) are naturally tax efficient, because they aren’t actively managed. Investors must be particularly careful when investing in some specialized funds, which can have the most dramatic gaps between pre-tax and after-tax returns. Consider the energy sector. One of the best 10-year annualized returns through August was reported by BlackRock Energy & Resources, at 18.11%. But its tax-adjusted return is significantly different: 15.5%, according to Morningstar.

    That 2.6 percentage point gap can make a big difference over time. An 18.11% average annual return over 10 years would turn $10,000 into $52,828; a 15.5% return would grow your money to $42,249.

  • Reshuffle investments between your tax deferred and taxable accounts, so you’re getting the best-after tax returns.

    Investments that generate the biggest tax bills, such as taxable bond funds, actively-managed mutual funds, dividend-paying stocks, Treasury Inflation Protected Securities, and real estate investment trusts should be held in a tax deferred account. “You want to postpone those taxes as long as possible,” says Sheryl Garrett, founder of the Garrett Planning Network based in Eureka Springs, Ark.

    Tax efficient investments, such as index mutual funds, exchange-traded funds, and municipal bonds, are good candidates for a taxable account.

     “The difference this can make shouldn’t be underestimated,” says Mark Cortazzo, senior partner at Macro Consulting Group in Parsippany, N.J.

    To make his point, Cortazzo uses an extreme but eye-opening example: Consider a 65-year-old couple with $1 million divided evenly between an IRA and a taxable account, with an S&P 500 index fund in the IRA and a certificate of deposit in the taxable account. They plan on withdrawing 5% of the portfolio each year to live on by pocketing interest from the CD and supplementing that by selling some stock.

    If, upon retiring, the couple leaves the stock holdings in the 401(k) and the fixed income investment in the taxable account, their money would dry up after 24 years, according to an analysis by Cortazzo’s firm. This assumes an average annual return of 7% in stocks and 3% in fixed income.

    If, instead, they flipped the investments and held the fixed income in their 401(k) and the stocks in their taxable account, by year 30 they would still have more than $155,000 in their IRA.

    Granted, this analysis doesn’t factor in that most investors hold various kinds of investments, and many don’t have as much in taxable accounts as they have in their 401(k)s.

    But the point still stands: To whatever extent you can improve your tax efficiency, go for it – it’s a risk-free move with a pay-off.