Tax strategies for retirees

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Authored by DST Systems, Inc.
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
Managing taxes in retirement can be complex. Thoughtful planning may help reduce the tax burden for you and your heirs.
Nothing in life is certain except death and taxes.
— Benjamin Franklin
That saying still rings true roughly 300 years after the former statesman coined it. Yet, by formulating a tax-efficient investment and distribution strategy, retirees may keep more of their hard-earned assets for themselves and their heirs. Here are a few suggestions for effective money management during your later years.

Less taxing investments

Municipal bonds, or "munis," have long been appreciated by retirees seeking a haven from taxes and stock market volatility. In general, the interest paid on municipal bonds is exempt from federal income tax and sometimes state and local taxes as well (see table).Footnote 1 The higher your tax bracket, the more you may benefit from investing in munis.
Also, tax-managed mutual funds may be a consideration. Managers of these funds pursue tax efficiency by employing a number of strategies. For instance, they might limit the number of times they trade investments within a fund or sell securities at a loss to offset portfolio gains. Equity index funds may also be more tax efficient than actively managed stock funds due to a potentially lower investment turnover rate.
It's also important to review which types of securities are held in taxable versus tax-deferred accounts. Why? Because the maximum federal tax rate on some dividend-producing investments and long-term capital gains is 20%.Footnote 3 In light of this, many financial experts recommend keeping real estate investment trusts (REITs), high-yield bonds, and high-turnover stock mutual funds in tax-deferred accounts. Low-turnover stock funds, municipal bonds, and growth or value stocks may be more appropriate for taxable accounts.

The tax-exempt advantage: when less may yield more

Would a tax-free bond be a better investment for you than a taxable bond? Compare the yields to see. For instance, if you were in the 25% federal tax bracket, a taxable bond would need to earn a yield of 6.67% to equal a 5% tax-exempt municipal bond yield.
Tax-Exempt Rate
12% 22% 24% 32% 35% 37%
Tax-exempt rate Taxable-equivalent yields
4% 4.55% 5.13% 5.26% 5.88% 6.15% 6.35%
5% 5.68% 6.41% 6.58% 7.35% 7.69% 7.94%
6% 6.82% 7.69% 7.89% 8.82% 9.23% 9.52%
7% 7.95% 8.97% 9.21% 10.29% 10.77% 11.11%
8% 9.09% 10.26% 10.53% 11.76% 12.31% 12.70%
The yields shown above are for illustrative purposes only and are not intended to reflect the actual yields of any investment.

Which securities to tap first?

Another major decision facing retirees is when to liquidate various types of assets. The advantage of holding on to tax-deferred investments is that they compound on a before-tax basis and therefore have greater earning potential than their taxable counterparts.
On the other hand, you'll need to consider that qualified withdrawals from tax-deferred investments are taxed at ordinary federal income tax rates of up to 37%, while distributions — in the form of capital gains or dividends — from investments in taxable accounts are taxed at a maximum 20%.Footnote 3 (Capital gains on investments held for one year or less are taxed at federal ordinary income tax rates.)
For this reason, it potentially could be beneficial to hold securities in taxable accounts long enough to qualify for the favorable long-term rate. And, when choosing between tapping capital gains versus dividends, long-term capital gains may be a consideration from an estate planning perspective because you could get a step-up in basis on appreciated assets at death.
It may also make sense to consider taking a long term view with regard to tapping tax-deferred accounts. Keep in mind, however, the deadline for taking annual required minimum distributions (RMDs).

The ins and outs of RMDs

The U.S. tax code generally mandates that you must begin taking an annual RMD from your employer-sponsored retirement plan accounts for the year in which you turn age 72, or if later, the year in which you retire. If you have a traditional individual retirement account (IRA), you must begin taking RMDs for the year in which you turn age 72, regardless of whether you are still employed.Footnote 4 The premise behind the RMD rule is simple — the longer you are expected to live, the less the IRS requires you to withdraw (and pay taxes on) each year.
Lifetime RMDs are calculated annually based, in most cases, on a life expectancy factor found in the IRS's Uniform Lifetime Table. Failure to take the RMD can result in an additional tax equal to 50% of the difference between the RMD amount and the actual amount distributed during the calendar year. Tip: If you'll be pushed into a higher tax bracket at age 72Footnote 4 due to the RMD rule, it may pay to begin taking withdrawals during your sixties.
Unlike traditional IRAs, Roth IRAs do not require you to begin taking distributions by age 72.Footnote 4 In fact, you're never required to take distributions from your Roth IRA during your lifetime, and qualified withdrawals are tax free, although distributions that are not qualified withdrawals are generally subject to income tax on the earnings portion and a 10% additional tax on the taxable portion, unless an exception applies.Footnote 2 For this reason, you may want to consider liquidating investments in a Roth IRA after you've exhausted other sources of income. Be aware, however, that your beneficiaries will be required to take RMDs after your death.

Estate planning and gifting

There are various ways to reduce the burden of taxes on your beneficiaries. Careful selection of beneficiaries of your retirement accounts is one example. If you do not name a beneficiary of your retirement account, the assets in the account could become distributable to your estate. Your estate or its beneficiaries may be required to take RMDs on a faster schedule (such as over five years) than what would otherwise have been required (such as ten years or over the remaining lifetime of an individual beneficiary). In most cases, naming a spouse as a beneficiary is ideal because a surviving spouse has several options that aren't available to other beneficiaries, such as rolling over your retirement account into the spouse's own account and taking RMDs based on the surviving spouse's own age.
Also, consider making gifts (either outright or by transferring assets into an irrevocable trust) if you're close to the threshold for owing federal estate taxes. In 2022, the federal estate tax applies to assets in an estate exceeding $12.06 million in value. Assets in a properly structured irrevocable trust are not subject to estate tax at your death. If your total lifetime gifts exceed the exemption amount ($12.06 million in 2022), they will be subject to gift tax. You should select the assets used to make gifts carefully, since appreciated assets that are gifted, unlike appreciated assets retained by you until death, will not receive a step-up in cost basis for income tax purposes at your death, potentially increasing the amount your beneficiaries pay in capital gains when the assets are sold. You may also reduce the estate taxes due at your death by taking advantage of the unlimited marital and charitable deductions for assets passed on to spouses and charitable organizations. (If assets are gifted during life or passed on at death to grandchildren, or more remote descendants, you must also plan for the federal generation-skipping transfer tax.)
Finally, you can give up to $16,000 per individual ($32,000 per married couple who elect to split gifts) each year to anyone without incurring federal gift tax or using any of your lifetime federal gift tax exemption amount. Also, consider making gifts to children or grandchildren to help save for their higher education expenses in Uniform Transfer to Minor Act or Uniform Gift to Minor Act accounts. The dividends and capital gains in these accounts may be taxed at the children's lower rates, although you must take into account the kiddie tax rules.Footnote 5 You may also make gifts to state-sponsored 529 plans for the benefit of children and grandchildren, distributions from which will not be subject to federal (and possibly state and/or local) income tax as long as the distributions are used only to pay qualified educational expenses. In addition, you may pay a child's or grandchild's tuition directly to the school without incurring gift tax or using any of your lifetime gift tax exemption amount.
Strategies for making the most of your money and reducing taxes are complex. Your best recourse? Plan ahead and consider meeting with a competent tax advisor, an estate attorney, and a financial professional to help you sort through your options.

The Coronavirus Aid, Relief, and Economic Security (CARES) Act provides that qualified coronavirus-related distributions made in 2020 generally are included in income ratably over a three-year period, unless you elected otherwise. However, you may repay all or part of the distribution within three years after the date the distribution was received. In such cases, you will not owe federal ordinary income tax on the distribution.

Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.

Income from investing in municipal bonds is generally exempt from Federal and state taxes for residents of the issuing state. While the interest income is tax-exempt, any capital gains distributed are taxable to the investor. Income for some investors may be subject to the Federal Alternative Minimum Tax (AMT).

Mutual funds are not FDIC insured; are not deposits or obligations of, or guaranteed by, any financial institution; and are subject to investment risks, including possible loss of the principal amount invested. Investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost.

Footnote 1 Capital gains from municipal bonds are taxable, and interest income may be subject to the alternative minimum tax.

Footnote 2 Qualified withdrawals are generally distributions that are made after you are age 59½, disabled or deceased, and, for a Roth-designated employer-sponsored retirement plan account, five years have passed since your first Roth contribution to the account, or for your Roth IRA, five years have passed since your first contribution to any Roth IRA.

Footnote 3 Income from investment assets may be subject to an additional 3.8% Net Investment Income Tax, applicable to single-filer and head of household taxpayers with modified adjusted gross income of over $200,000 and $250,000 for joint filers and qualifying widow(er)s with a dependent child.

Footnote 4 This age was increased from 70½, effective January 1, 2020. Account holders who turned 70½ before that date are required to begin RMDs after reaching age 70½.

Footnote 5 Annual unearned income between $1,150 and $2,300 is generally taxed at the child's tax rate, and unearned income over $2,300 generally is taxed at the parents' tax rate if the child is under age 18, or if the child is age 18 and does not have earned income that is more than half of his or her financial support, or is a full-time student that is at least 19 and under age 24 who does not have earned income that is more than half of his or her financial support if at least one parent is living at the end of the tax year and the child is not filing a joint return.

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The material was authored by a third party, DST Retirement Solutions, LLC, an SS&C company ("SS&C"), not affiliated with Merrill or any of its affiliates and is for information and educational purposes only. The opinions and views expressed do not necessarily reflect the opinions and views of Merrill or any of its affiliates. Any assumptions, opinions and estimates are as of the date of this material and are subject to change without notice. Past performance does not guarantee future results. The information contained in this material does not constitute advice on the tax consequences of making any particular investment decision. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation, offer or solicitation for the purchase or sale of any security, financial instrument, or strategy. Before acting on any recommendation in this material, you should consider whether it is in your best interest based on your particular circumstances and, if necessary, seek professional advice.

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Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.