Formulating a retirement plan and deciding on your "retirement number" -- the amount you need to save up before you clock out for good -- is the easy part. Actually sticking to your plan and making sure all your T's are crossed and your I's dotted -- now that's the challenge.
The currently retiring baby boomer generation serves as a perfect example of what happens when a large number of pre-retirees don't stick to the game plan.
According to a recent study from the Insured Retirement Institute, around 40% of all boomers don't have a single cent saved toward their retirement, including half of already retired boomers. For the boomer generation, this means either putting their retirement off for a few years (or longer) or relying heavily on Social Security benefits. The danger of the latter is that the Old-Age, Survivors and Disability Insurance Trust, from which some 59 million beneficiaries were paid monthly in 2014, is set to burn through its remaining cash reserves by 2033. If Congress is unable to find a way to boost revenue, cut expenses, or deliver some combination of the two, Social Security benefit checks will drop by 23% to ensure the longer-term survival of the program.
The unpreparedness of boomers for retirement is just the kick in the behind Americans need to look for ways to stick to their game plan and boost their income both now and in retirement.
Keep more of your hard-earned money
With that in mind, today we'll look at three tax-advantaged investment tools you can use to keep more of your money now and in retirement.
What is a tax-advantaged investment tool? It's a type of investment or account that offers some form of tax benefit. These benefits include up-front tax breaks and tax-free investment gains.
If you're looking to boost your income now or in your golden years, the following three tax-advantage investment tools may appeal to you.
1. IRAs and 401(k)s
Arguably the best-known tax-advantaged investment vehicles in America are individual retirement accounts and employer-sponsored 401(k)s.
There are quite a few different types of IRAs, but let's focus on the two most common: the traditional IRA and the Roth IRA. Anyone aged 49 and under can contribute up to $5,500 to an IRA in 2015, and those aged 50 and older can contribute an extra $1,000.
Traditional IRAs grant the accountholder an upfront, dollar-for-dollar tax deduction against their taxable income in the current tax year. If they contribute $5,500, they can deduct $5,500 from their taxable income. Traditional IRAs allow your money to grow on a tax-deferred basis, with the accountholder paying ordinary income taxes only when they begin making withdrawals, which they must begin taking between the ages of 59-1/2 and 70-1/2. Any unqualified withdrawals before age 59-1/2 come with a penalty. Additionally, traditional IRAs require the accountholder to begin withdrawing a minimum amount each year starting at age 70-1/2.
A Roth IRA doesn't have any upfront tax benefits, but for many savers it can actually be more lucrative over the long run. The big difference here is that investments in Roth IRAs are completely free of taxation, so long as the withdrawals are qualified. Additionally, Roth IRA accountholders can continue to contribute beyond their 70th birthday and aren't required to begin taking withdrawals by age 70-1/2. Note that there are income limitations to contributing to a Roth IRA. For instance, if you're married and filing jointly, contribution limitations begin to kick in at a modified adjusted gross income of $183,000. For a single filer, the limitations kick in at $113,000 in MAGI. To see whether you meet the income limit to contribute to a Roth, you can visit the IRS' website for full details.
A 401(k) is an employer-sponsored plan that allows an employee to save up to $17,500 for retirement in 2015. What makes these plans so attractive is that taxes are deferred until you begin making withdrawals during retirement, and many businesses actually match a certain percentage of your contribution.
For instance, integrated oil giant ConocoPhillips contributes as much as 9% of its employees' annual salary to their 401(k) in addition to the employees' contribution, even if that contribution is as small as 1% of their salary. However, employers typically match every dollar, or $0.50 on the dollar, up to 2% or 3% of the employee's salary. The 401(k) plan's combination of tax advantages and potential employer matches makes it arguably the best tool for helping working Americans stay on track for retirement and keep more of their hard-earned money.
2. Municipal bonds
Municipal bonds, also known as munis, are a particularly popular tax-advantaged tool used most often by upper-income individuals because they're usually free from taxation.
Municipal bonds are a type of debt security issued by local or state governments in order to finance a project, such as building a highway, bridge, or school. States and cities aren't made of money, so they'll occasionally turn to municipal bond offerings in order to raise the necessary cash. In return for lending a city, county, or state your money, you'll earn a predetermined amount of interest each year. Whereas interest on bonds is typically taxable, interest income earned from municipal bonds is free from federal taxation. Although it varies from state to state, you may also be free of state and local taxes, too, if you happen to live within the city, county, or state where the muni bond originated.
It's important to keep in mind that while most muni bonds are safe investments, nothing in the investment world is guaranteed, and it's still possible to lose money if a municipality is unable to make its interest payments or declares bankruptcy. Again, this is uncommon, but it's vital that you do your homework on the city, county, or state bond you're investing in and understand the risk factors involved in buying a muni bond.
3. MLPs and REITs
Two other important tax-advantaged tools that retirees and upper-income folks particularly like are master-limited partnerships and real estate investment trusts, commonly known as MLPs and REITs, respectively.
MLPs are publicly traded companies that typically invest in energy infrastructure assets such as pipelines, but you can also occasionally find commodity-based MLPs, too. As partnerships, MLPs are exempt from corporate taxation on their profits. Instead, the taxes become the responsibility of the unitholder, which is a fancy term for shareholder.
Now here's the catch: MLP distributions (another word for dividend) aren't just your run-of-the-mill taxable payout. Instead, MLP distributions are classified as a return of capital until you sell your investment or until you've recouped the full value of your initial cost basis. What this means is that your cost basis will drop with each distribution, but until you sell your stock or recoup your initial investment, you won't owe a cent in taxes. That's a potentially big benefit for retirees, especially considering the superior yields of some MLPs.
REITs are publicly traded companies that invest in real estate. In order for REITs to qualify for a free pass from corporate taxation, they're required to return at least 90% of their income as a dividend to unitholders. REIT dividends are taxable to unitholders, but most will wind up paying far less in taxes than initially expected.
You see, the way REITs account for real estate asset depreciation and accelerated depreciation can affect their bottom line, which is important, as their bottom line determines the dividend payout you receive. Thus depreciation, along with a few other expenses, can sometimes lead to a portion of your dividend being treated as a return of capital. As with an MLP, a return of capital lowers your cost basis, with the unitholder paying capital gains taxes only when he or she sells the stock.
Long story short, there are plenty of investment vehicles out there designed to allow you to keep more of your hard-earned income. The question is, will you take action?
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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