Pay less tax when planning for retirement

By Walter Updegrave, senior editor


(Money Magazine) -- Question: I have been contributing the maximum to my 401(k) for some time now. But are there any other tax-friendly ways I can save even more for retirement? -- David W., Carlsbad, Calif.

Answer: It's always a good to idea to make the most of tax-advantaged savings accounts and investments in your retirement planning. They're a smart way to leverage your savings effort.

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).
How do you see your finances one year from now?
  • Investments up and job more secure
  • Investments up, but job shakier
  • Investments down, but job more secure
  • Investments down and job shakier

But now is an especially important time to make sure you're not overlooking any opportunities to save and invest in a tax-efficient way.

Why? Well, taxes could soon take a bigger chunk of your paycheck and investment gains. The Bush administration tax cuts are scheduled to expire at the end of this year. If that happens, the top income tax rate on ordinary income will climb from 35% to 39.6%, the maximum rate on long-term capital gains will increase from 15% to 20% and the top rate on dividends will jump from 15% to 39.6%.

I say "if that happens" because at this point it's an open question whether, given the still-fragile state of the economic recovery, Congress will let tax rates rise next year. Our legislators could decide to postpone the looming rate hike altogether or, barring that, limit the number of people any tax increase would affect.

Regardless of how this plays out, however, there's another tax increase that's definitely coming in 2013 courtesy of health care reform. Starting that year, high-income households will not only have to pay more Medicare tax on wages, they may also face a 3.8% Medicare levy on net investment income. That represents a radical departure from current policy under which the Medicare tax applies only to wages and net self-employment income.

Bottom line: When you combine whatever tax rate you currently face with the possibility of additional levies in the future, you want to be sure you're taking all the reasonable steps you can to save and invest in a tax-savvy way.

So what might those steps be if you're already maxing out your 401(k)?

Even though you already participate in your company plan, you may still be able to contribute as much as $5,000 a year (plus an extra $1,000 if you're 50 or older) to a traditional deductible IRA or Roth IRA. (For the pros and cons of each type, click here.

For example, if you're single and earn less than $120,000, you can make at least a partial contribution to a Roth IRA. To see which type of IRA, if any, you qualify for, you can check out this IRS bulletin or go to this calculator. If you're married, don't forget to see whether your spouse can also contribute to an IRA.

If you don't qualify for a traditional deductible IRA or Roth IRA, there is an indirect way to get money into a Roth. That route: open a nondeductible IRA, which anyone under age 70 ½ with earned income can do, and then immediately convert that nondeductible IRA to a Roth IRA. For details on this run around the Roth annual contribution rules, click here.

If you have self-employment income of any kind -- earnings from a consulting business, freelance work, etc. -- you may also be able to save extra bucks through tax-advantaged programs geared to the self-employed and small business owners. Two such plans: the SEP-IRA and the solo 401(k), both of which allow for contributions of as much as $49,000 this year (plus an extra $5,000 in the case of the solo 401(k) if you're 50 or older). For more on how these accounts work, click here.

If you've fully funded tax-advantaged savings plans and you've still got money left to sock away for retirement, you can move on to tax-efficient investments in taxable accounts. Granted, you won't qualify for a tax-deduction as with a traditional IRA or tax-free withdrawals as with a Roth. But by investing in such tax-friendly investments as index funds, ETFs and tax-managed funds, you have a shot at boosting after-tax returns several ways.

First, these investments typically limit taxable distributions, which keeps more of your money working for you. Second, by delivering the bulk of their return in the form of long-term capital gains, your profits are taxed at the more favorable long-term capital gains rate. And third, since the return of such funds consists mainly of an increase in share price (as opposed to ongoing interest payments or dividends), you don't have to realize a gain -- or pay tax on it -- until you actually sell. The longer you hold, the more your gains compound without the drag of taxes.

For suitable index funds and ETFs, you can check out our MONEY 70 list of recommended funds. To find tax-managed funds, type the words tax managed into the Quote box at Morningstar.com.

One final note: While you want to be tax smart when it comes to saving and investing for retirement, you don't want to become tax paranoid, by which I mean you get so obsessed about avoiding taxes that you sabotage yourself. So I'd be very wary of getting into high-cost investments that are often touted as tax dodges, like many insurance policies and annuities.

Remember, your ultimate goal isn't to avoid paying taxes. It's to build a nest egg that can support you in retirement. To top of page

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