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. 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
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. 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
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.
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