How to Invest for a (Mostly) Tax-Free Retirement

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"Tax-free retirement" has a nice ring to it. If, like two-thirds of Americans, you are unsure you've saved enough for your out years, it's especially nice to know that Uncle Sam won't be pinching a slice of your meager pie. Or maybe you're an ample saver convinced by the tax talk in Washington that the feds will undo your careful planning by raising taxes by the time you call it quits.

No wonder financial advisors say that current clients and prospects have taxes on their minds, or that titles containing "tax free" are popping up on the personal finance shelves at the bookstore.

As enticing as a completely tax-free income stream may sound, however, it's difficult to create. The most common retirement savings vehicles, tax-deferred IRAs and 401(k)s, are unwieldy investments when it comes to taxation. And while most retirees have less income to tax, they also have fewer deductions, reducing the opportunities to shelter their reduced revenue.

Some financial advisors question whether avoiding taxes should be a priority at all in retirement planning.

"The goal is not to pay the least tax possible but to maximize the after-tax return," said Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research.

But there's good reason to pursue as much tax-free income as possible.

"If you ignore their impact, taxes can change the old mantra that you can live on 80 percent of what you make pre-retirement," said Greg Stevens, senior financial counselor at Cabot Money Management, in Salem, Mass.

At a time of life when returns are low and health-care expenses are high, it makes sense to preserve every retirement dollar you can.

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Roth IRA

The retirees' primary source for tax-free income is the Roth IRA. After-tax dollars go in and grow tax-free, and you pay no tax on withdrawals. Roths have an advantage over municipal bonds, the time-honored tax-free instrument because, unlike with munis, Roth disbursements aren't counted as income for early recipients of Social Security, whose payments are docked if they make as little as $15,000.

Roth income is so advantageous that it makes sense to moving funds from other instruments such as 401(k)s and traditional IRAs and pay any taxes owed with the conversion.

Many retirees wait to convert until their first year of retirement, when they have no more employment income, leaving them in a lower bracket, but the conversion can be made anytime it's reasonable. The key is to avoid incurring higher taxes now in the name of avoiding them later, according to Stevens.

"The question is, do you have any room in your current tax bracket to make the Roth conversion?" he said.

By converting, the tax-averse also rid themselves of the mandatory—and taxable—withdrawals from IRAs and 401(k)s that come at age 70-and-a-half.

"A client who has $1.5 million in [taxable] funds is looking at required minimum distributions of more than $50,000," said Curt Knotick, a financial planner in Butler, Pa. "Add pension and Social Security, and they should begin premature distributions to convert to a Roth."

Insurance for income

It's not likely, however, that you'll have enough assets in a Roth IRA to provide all you'll need for retirement. The next stop in the search for tax-free income is the insurance agent.

With the collapse of traditional pensions, insurers have seen increased interest in annuities, which produce guaranteed monthly payouts in exchange for a chunk of your savings.

When funded by a Roth IRA, one type of annuity—an immediate fixed annuity—gives its owner an income stream that's not only tax-free but guaranteed for life. Even those funded by taxable savings can yield low-tax income because each monthly payment contains a small slice of your premium, which has already been taxed.

The life insurance retirement plan is another, more specialized, income-bearing product. Essentially a massively overfunded universal life policy, a LIRP allows the owner to withdraw the policy's excess cash tax-free and take loans that will be repaid from the its benefit when the owner dies.

Not everyone agrees that insurance is the best source of income, tax-free or not. Because the company has to take its cut and pay a death benefit, fees attending these investments tend to be high.

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In addition, annuities require relinquishing control of your cash for long periods, if not permanently. A standard tool in many retirement planning schemes, annuities are more often used to guarantee that basic expenses are covered rather than to avoid taxes. And all but their most ardent advocates agree that the costs and complexity of LIRPs make them a solution more for high earners who have maxed out conventional retirement savings vehicles and are still seeking shelter.

Portfolio management

Most retirees will have taxable income; the amount of tax will depend on how money is made and where it is placed.

"You want to manage your portfolio," said Spiegelman at Schwab. "You want your most tax-efficient investments in your taxable account and [least-efficient investments] in deferred."

Specifically, that means keeping high-earning stocks quarantined in IRAs or 401(k)s, where all the income will be put to best use. Low-turnover investments and securities aimed at growth rather than income can live happily in a regular brokerage account, along with exchange-traded funds.

"Then in retirement you have assets that have appreciated nicely over the years, but when you sell them, you pay capital gains, not ordinary income rates," Spiegelman said.

"Even if taxes are what worry you, the first priority is asset allocation," he said. "Making the right investment decision comes next. Then be choosy about where you implement the portfolio."

Above all, financial advisors say, stay nimble, and don't put your assets into any single strategy with the purpose of minimizing taxes or, especially, getting free of the whims of Congress. Staying tax-free, as Stevens pointed out, is a necessary losing game.

"If everyone goes into no-tax investments," he said, "leave it to Congress to take away the deductions."