There is a chance, albeit an outside one, that your tax rate in retirement might be equal to or greater than it is right now. If you are currently in a high tax bracket and assume for whatever reason (you haven’t put enough a way or you plan on living on far less than you are currently taking home) that you taxes will be lower during your retirement, you might want to rethink your plan. If you are currently in a more favorable tax bracket, the chances of your post-retirement filing obligation will be far less, think again.
We have no idea what the tax rate will be in retirement. While we can estimate inflation, we can calculate our distribution and even chart our plan’s diversity, the one unknown is how this tax-deferred account will fair once tax rates are applied. But there is a way to potentially hedge that unknown factor and get some satisfaction should you be wrong or right.
A recent article in Investment News suggests that there are a great number of mutual funds who have what is known as a tax hangover. According to Jeff Benjamin, “Embedded capital losses, which represent a combination of realized and unrealized losses, offer a rare opportunity for mutual fund investors in taxable accounts.” This is one reason why you should have a taxable acocunt as well as a tax-deferred one.
The way your retirement should be structured flies in the face of some of the more popular “max-it-out” theorists who think that doing so will only be more beneficial. But switching to a taxable account once you reach the 6-10% contribution range might prove more profitable in the long run. I have suggested that the most tax efficient funds be used for this purpose, and during normal times, paying the taxes that index funds generate would be the best investment option.
This index fund should be kept in a Roth IRA, an after-tax product that is gaining favor among those who have too much to invest and few good places to put it. Even if you aren’t burdened with such a problem, taking the time to max this account once you hit the 6-10% mark in your 401(k), will give you an excellent opportunity to hedge your tax bet and take advantage of this rare moment when the funds you invest in might be feeling the benefits of this tax overhang.
Now this does mean, at least in the short-term, to get the benefit of this you will need to abandon the index funds you may have had in this account. But two things have had to have happened before any of this can take place.
One, the fund will have had to lose money, a lot of it, in order to be worth the effort. There are a lot out there, who as result of their own puffery overextended when they should have seen what was coming. They are the active managers, the high-flyers index fund aficionados warn will cost you money in the long-run (even if their gains have the potential to offset any fees they might charge). And you have to get into the fund before the distribution is made.
As mr. benjamin points out, “Unlike capital gains and income distributions, which mutual funds are required to pass through annually to shareholders, losses can’t be passed through to shareholders. But those losses, once realized through the sale of a security, can be used to offset a fund’s distributions from investment gains.”
But Mr. Benjamin’s argument has some substance, if only in the short-term. he does warn you not to abandon your investment guidelines to take advantage of this opportunity, making sure that you focus on the cost of the fund, the tenure of the manager and long-term prospects of the fund based on a long-term look at where it has been. He writes that: “a fund with a 100% tax-loss overhang could double in size without paying out a capital gains or income distribution that would be subject to tax.” This an opportunity that might be too good to believe and too good to pass up.
More on Mr. Benjamin’s article in Investment News
Related posts: