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Don't let the name fool you. The recently passed American Taxpayer Relief Act may have averted the first of a likely series of "fiscal cliffs," but there was little relief for prospective retirees.
Payroll taxes have gone up. Dividend taxes have risen. Itemized deductions for the highest earners are now limited. (For further detail, see "Taxes: A Guide to 2013's Big Changes.") And all that is in addition to the Patient Protection and Affordable Care Act upheld by the Supreme Court last year, which imposes a 3.8% surtax on net investment income for couples with a modified adjusted gross income (MAGI)1 of $250,000 or higher ($200,000 for singles) and an extra 0.9% Medicare tax on earned income.
At the same time, millions of Americans, particularly baby boomers who are 50–65, are staring at a fiscal cliff of their own. Or, perhaps, call it a "retirement ravine": Thanks to modern medicine, baby boomers are living longer, but many haven't saved nearly enough to retire or, for that matter, pay for health care before Medicare kicks in at age 65 (assuming they're still eligible). And there is no telling how much Medicare will pay for when millions of other boomers become eligible over the next decade.
As a recent paper by the AARP Public Policy Institute put it, "Those that do save often contribute too little, invest poorly, or withdraw funds early. These patterns leave households... vulnerable to insufficient savings to finance adequate living standards during old age and retirement. Looking ahead, the retirement of the baby boomers, the aging of the population, and rising healthcare costs will place increasing pressure on Social Security and Medicare, making achieving a secure retirement even more challenging for many. As Congress considers budget reform, proposals to strengthen the private retirement system should be given serious consideration."
What can an individual do in the meantime (besides saving more, spending less, and consulting one's financial advisor)? Consider the following.
A Muni-Splendored Thing
One investment option that has drawn greater attention is to allocate more funds into tax-free municipal bonds, since interest from those bonds remains exempt from federal taxes in most cases. [It should be noted that the income from municipal bonds may be subject to the alternative minimum tax, however.]
Now that the top marginal tax bracket has risen from 35% to 39.6% in 2013, the taxable equivalent yield of a hypothetical municipal bond with a yield of 4.00%2 would be more than 6.6% at the highest tax bracket (5.5% in the 28% bracket)—a rather enticing prospect in a slow-growth environment fraught with uncertainty.
The Greats of Roth
Another option advisors may want to broach to their clients is converting a traditional IRA to a Roth IRA, which would potentially enable tax-free withdrawals, but now there are more factors to consider. For one thing, conversion could be subject to a 20% capital gain rate (versus the previous 15%). For another, the proceeds could put you in the top tax bracket of 39.6% (versus the previous 35%), while dividend taxes are also going up and itemized deductions and personal exemptions for certain taxpayers are being phased out. Then there's the 3.8% investment income surtax that recently took effect. (See Table 1 for examples of what will and will not be considered investment income.)
Source: Ed Slott's IRA Advisor, May 2010, and Smart Money, June 28, 2012.
The question isn't at what age I want to retire, it's at what income. —George Foreman
Retirement is like a long vacation in Las Vegas. The goal is to enjoy it to the fullest, but not so fully that you run out of money. —Jonathan Clements, The Wall Street Journal
Maximize Your Pretax Contributions
Last, but not least, don't forget to contribute as much as you can to a retirement plan on a pretax basis, whether it's to a 401(k), a 403(b), or a 457 plan. Not only will that help lower your MAGI but also it potentially might reduce or eliminate your exposure to the 3.8% surtax on net investment income.
Brian Dobbis, a Lord Abbett Retirement Analyst—Private Wealth Group, serves as the firm's IRA technical resource. He also manages Lord Abbett's 403(b) and 457 business channels. A graduate of Rowan University, Mr. Dobbis began his career in the financial services industry in 1996. He joined Lord Abbett in 2002, and held the positions of Retirement Consultant and Retirement Research Associate. He is recognized by the American Society of Pension Professionals and Actuaries as a Qualified 401(k) Administrator, a Qualified Plan Administrator, and a Qualified Plan Financial Consultant.
Risks to Consider: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. The income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-free income. In addition, bonds may be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. No investing strategy can overcome all market volatility or guarantee future results.
Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.
A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.
Taxable equivalent yield is the pretax yield that a taxable bond needs to possess for its yield to be equal to that of a tax-free municipal bond. It does not reflect state and local income taxes or the alternative minimum tax, if any and will vary based on each investor's tax bracket.
Please note that there may be administrative fees and other costs involved in a conversion to a Roth IRA.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.