Retirement: Minimize taxes to maximize savings
Retirement planning is hard enough for most Americans. But when you layer in a convoluted web of U.S. tax laws, the task can seem truly overwhelming.
Some complexity is unavoidable. After all, how much you make, when you choose to retire and how much you'll need in retirement can vary greatly from family to family.
But the good news is that while there are no universal truths to retirement and tax planning, there are some common rules of thumb that the typical American should follow when trying to minimize taxes and maximize retirement savings.
Here are a few pointers to ensure the tax man isn't taking too much of a bite out of your investments, and to ensure you keep more of your money to reach your financial goals.
• Max Out Your 401(k). In many cases, the most tax-efficient way for you to save for retirement is to max out an employer-sponsored 401(k) or 403(b) with pre-tax dollars taken out of your paycheck. By allocating pre-tax dollars from your wages to your retirement plan, you not only reduce the total amount you pay in income taxes, but also jump-start your portfolio by putting all of your savings to work immediately.
Think of it this way: Investing $1,000 directly in a 401(k) each month grows your nest egg much faster than getting paid $1,000, paying 20% in taxes, and then investing the $800 that is left.
The tradeoff is that 401(k)s are inflexible, and you have to pay steep penalties if you withdraw that cash before you're age 59½. But if you're playing the long game, then take full advantage of your 401(k). The maximum you can contribute in 2015 is $18,000 annually, with those 50 and older eligible to save another $6,000 in "catch-up" contributions.
• Avoid booking short-term profits. If you are investing in a taxable investment account, it's crucial to watch the holding period on your investments.
That's because an additional Medicare tax implemented in 2013 has pushed the top tax rate for investment income to 39.6% for top earners who sell investments less than one year after initially buying them. In other words, a $100,000 profit becomes just $60,400 after taxes.
Compare that with a maximum rate of 20% for top earners if they hold your investments for a year and a day — in which case you would take home $80,000 after taxes.
The numbers are stark here, so unless there's an incredibly compelling reason to sell quickly and protect profits, you may ultimately come out with more cash if you wait to exit your investments.
• Always use first in, first out. What if you've bought into a given stock or fund at different prices across the years, with some profits but also some periods where you may have lost money in the same investment?
Unfortunately, you can't just pick the best possible price and timing when you sell. The default method used by the IRS is called "first in, first out" (FIFO), and like the phrase implies, you have to use the lots and cost basis of shares purchased first before you can use the later transactions.
If that lot isn't big enough to fulfill the entire sale, move to the next oldest transaction and average them together.
In short, it's a big no-no with the IRS to cherry-pick transactions to reduce your tax burden. If you do, this may actually open the door for an audit and steep penalties if you are caught.
• Plan to pass on stocks, not cash. If you're lucky enough to have investments that have appreciated a lot in value and plan to pass on your wealth, don't cash out and don't gift the shares before you die. That's because tax rules allow heirs to treat the "purchase price" of their inherited stock as the price at the date of your death.
If you simply sell before you die, you'll have to pay taxes on years or even decades of profits, and if you gift the stock before death then you pass on your original cost basis and the potential tax burden.
If your family doesn't need the money immediately, it may be wise to consider passing on actual shares of stock after your death to reset the cost basis and reduce capital gains taxes as a result.
Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor's Guide to Finding Great Stocks.