Save Big On Taxes (While There’s Still Time)

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It’s that time of year again. Tax Day is just around the corner.

If you have not yet filed – or even if you have – there is still some time to save big on taxes.

And there’s a double-benefit: By making smart changes to your retirement planning decisions, you’ll both improve your retirement planning as well as trim your tax bill.

Here are some tips for how you can save for retirement in a more tax-savvy manner … thereby keeping more money in your nest egg, even if you can’t save more.

Your 401(k): Hit the Match

Your 401(k) plan is a great place to start. Because 401(k) contributions are tax-deferred, you can achieve some tax savings right away by increasing your monthly contributions. If you have not started making contributions, or if you are not contributing up to the full employer matching amount, now is the time to get started.

The maximum annual individual contribution to an IRA is $17,500 for people 49 and under, plus an extra $5,500 if you’re 50 or older. That would be a nice amount of money to subtract from your gross taxable income. At a minimum, though, do your best to contribute up to the employer matching level. That’s money you don’t want to leave on the table.

Open an IRA Account

Another way to score some quick tax savings would be to open an IRA account. You can contribute a maximum level of $5,500 annually to a traditional IRA. (If you’re 50 or older, you can contribute an extra $1,000.)

So all told, people ages 49 and under could be reducing your tax bill by $23,000 just by investing up to the maximum limits for your 401(k) and IRA plans. People ages 50 and older can add an extra $6,500 to that total.

Any additional contributions made before April 15 will count towards your 2013 taxes, as long as you mark it as a “prior year contribution.”

Invest With Tax Smarts

Tax considerations should not drive investment decisions, but you should take smart steps to minimize the tax impact of these decisions.

Perhaps the most important choice is optimizing your asset location, which we will talk about in more detail below. But there are some other common-sense things you can do as well:

Keep An Eye Out For Churn

“Churn” is the popular Wall Street term for frequent turnover of asset positions.

Brokers get paid on a commission basis, which means they can earn money every time they buy or sell securities in your account.

For you as an investor, though, churn hurts in two ways. First, you pay more trading costs, which can reduce your net return. Second, high turnover can generate short-term capital gains. These are taxed at a higher rate than long-term gains, especially for taxpayers who are in higher income brackets.

A moderate amount of turnover is reasonable for most investment strategies – but excessive levels should present a red flag.

Manage Your Glide Path

Your “glide path” is the changing composition of your asset allocation as you move through your key earning years towards, and beyond, retirement.

All investment strategies balance the needs for growth and income. A tax-savvy investor will manage this glide path carefully, increasing the income component gradually. The higher the capital appreciation component of your total return, the more you defer taxes into the future, and the lower the rate you pay.

Optimize Your Asset Location

Asset allocation is the most important decision you can make for long term investment success. But there is a second decision – asset location – that also plays a big role in getting you to your retirement goals. Locating the right assets in the right tax-advantaged vehicle help keeps more of your money working for your retirement, and less going to the tax man.

Think of it this way. Let’s say that you have an asset allocation of 60% equities and 40% fixed income. Assume further that you have two retirement accounts: one traditional IRA or 401(k) plan. You also have one taxable brokerage account. How should you invest the accounts?

Your first thought might be to invest both accounts identically along the 60/40 split. Here’s why that would not be the tax-optimal approach:

Your fixed-income assets are likely to generate much more taxable income – from interest and principal payments – than your equity assets. So rather than applying the 60/40 split to each account, it would make sense to load up the tax-advantaged account with your fixed income assets, keeping the more tax-friendly equities in the taxable account.

Location In Action

Here is an example to show the kind of real impact smart asset location can produce.

Let’s assume that we have two investors: Jack and Jill. Both have portfolios with $100,000.

Both have the same asset allocation, which is:

Both choose broad-market index funds and ETFs to represent each asset class, such as the Barclays Aggregate Bond Index, the iShares U.S. S&P 500 Index, and the SPDR S&P 600 Small-Cap ETF (to name a few).

However, Jack does not tax-optimize his portfolio. Jill does.

Here’s the composition of their portfolios:

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* Note the starting allocation changes over time due to the rebalancing in the portfolio

How do their returns change?

After 20 years, Jack has $681,312 in his portfolio. Jill has $704,219 in hers.

In other words, Jill’s portfolio gained an additional $22,906 just by optimizing her tax location.

(This scenario is for illustrative purposes only, and does not reflect or make any assurance about actual past, present or potential future outcomes.)

Final Thoughts

You can make plenty of moves to both reduce your tax bill and improve your retirement situation. Services like Jemstep can help you develop an unbiased strategy that can guide you through these important decisions.

Don’t leave your retirement planning and tax planning to chance. Take control of your planning today.