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Avoid hidden tax triggers in retirement
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Tax season is upon us – but before you break out that box of old receipts in search of every last deduction, think about whether you’re taking advantage of all the tax benefits associated with saving for retirement.
Your nest egg generally can be divided into three categories, at least from a tax perspective: assets that are taxed now, those that carry special tax advantages and those that will be taxed later.
Assets that are taxed now include mutual funds, stocks and certificates of deposit. They’re purchased with after-tax income, and investors pay short- or long-term capital gains taxes on their profits after they sell or cash in the assets. These types of assets carry two hidden tax risks, too.
The first hidden tax risk, turnover, afflicts investments like mutual funds. Over the course of a year, managers buy and sell securities to ensure that the fund adheres to its stated objective and to lock in gains on securities within the fund. So if a fund advertises a turnover ratio of 25 percent, then the managers executed trades that represented one-quarter of the fund’s total assets. Turnover can trigger capital gains, which investors must pay taxes on.
The other hidden tax risk is rebalancing. Many people sell assets that have grown in value and then buy securities whose value has decreased in order to bring their overall asset allocation back into balance.
For instance, if mutual fund A jumps in value while mutual fund B plunges, then fund A will comprise a greater percentage – and fund B a lesser share – of an investor’s portfolio. Selling A and buying B can allow an investor to position his portfolio in line with its original strategy. Unfortunately, the gains on the sale are taxable.
With these risks in mind, it’s worth asking yourself whether you’re needlessly paying taxes now on income that you may not actually use until sometime in the future.
In short, are you capitalizing on tax-advantaged and tax-deferred savings vehicles? That arguably is the single-best way to take control of your tax risks. It also has the salutary effect of maximizing your retirement income.
Tax-advantaged assets include such vehicles as Roth Individual Retirement Accounts (IRAs). Investors contribute to a Roth IRA with after-tax income but typically can withdraw their money – including any gains – tax-free as long as they comply with certain requirements.
On the downside, the assets within a retirement account are subject to the vagaries of the market. Savers also are subject to income and contribution limits when using Roth IRAs.
Traditional IRAs, qualified retirement plans like 401(k)s, cash-value life insurance and annuities represent types of assets that are taxed later. Some of these savings vehicles require a saver to withdraw a portion of the funds once he reaches a certain age. When withdrawn, the proceeds generally are taxed as regular income.
Of this third category, annuities provide savers with the greatest flexibility. Holders of annuities can control their tax burden, as they don’t pay taxes on any earnings until they withdraw funds. They also have access to professionally managed investment options and can avoid the tax risks associated with rebalancing their portfolios.
Further, annuities are the only vehicle that can provide savers guaranteed retirement income that’s insulated from potential market downturns, while leaving the possibility of a death benefit for an investor’s heirs.

Perlin is vice president of client effectiveness and education at Prudential Annuities.

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