Do you want to avoid overpaying taxes when you retire?  Safe money products could be the solution.

“The higher your income, the more critical tax-efficient investing becomes.”

Nearly every American understands that taxes are one of their most significant expenses. Wealth planners regard taxes and inflation as the two most erosive forces impacting savings. Tax planning strategies are critical components of sound retirement planning, even for those in mid-to-low income brackets.

So, what can individuals do to shield as much of their wealth as possible from the negative consequences of tax hikes? What role do fixed investments, such as life insurance, bonds, or annuities, play in helping retirees avoid overpaying taxes?

Fixed income

What is “fixed” income anyway?

Fixed income, referred to by some advisors as “safe money,” is a somewhat broad term used to describe a class of assets and securities that pay you a fixed interest rate of dividend payments until a specific date. Government and corporate bonds are one common type of fixed-income product that may be familiar to you.

Many fixed-income securities repay your principal investment and any interest you have earned. Unlike many types of stocks, variable-income securities, or other assets, the payments of fixed-income securities are predictable. Fixed products pay you the same amount throughout the term. Specific types of fixed products, such as certain fixed index annuities, often have the option for lifetime payouts and may be an ideal method of creating additional income streams for retirement.

You can purchase most fixed-income products directly. There are also many fixed-income “exchange-traded funds (ETFs) and mutual funds. Although traditional portfolio design maintains that a 60/40 ratio of safe money to equities is a good rule of thumb, there’s truly no “perfect” amount of safe money (fixed) products to add to your retirement matrix Fixed-income products are often the perfect solution for more conservative pre-retirees who understand how crucial a diverse portfolio is in today’s volatile economy. Depending on your investment style, goals, and risk tolerance, you and your advisor can design the mix of fixed products and equities that works best in your situation.

Fixed Income

Fixed-income product examples:

Treasuries, municipal bonds, fixed annuities, corporate bonds, and certificates of deposit (CDs) are some standard fixed-income products.

As mentioned previously, a government or corporate bond is the most common example of a fixed-income security. Bonds are bought and sold over-the-counter (OTC) and also on the bond and secondary markets.

Government bonds issued by the U.S. government are typically called Treasury securities or simply “treasuries.” However, foreign governments and corporations also offer fixed-income securities.

Some popular fixed-income securities include:

  • Treasury notes (T-notes) Sold in multiples of $100, T-notes pay fixed interest rates. These products have maturities between two and ten years.
  • Treasury bonds (T-bonds). T-bonds are similar to T-notes but have a longer maturity of 20 or 30 years. You purchase Treasury bonds in multiples of $100.00
  • Treasury bills “T-bills.” Short-term fixed-income securities that mature within one year, T-bills don’t pay coupon returns. Instead, you buy the T-bill for less than face value. You then earn the difference when the bill matures.
  • Treasury Inflation-Protected Securities. Another safe money option is Treasury Inflation-Protected Securities or TIPs. TIPs may help buffer your wealth against inflation.
  • Municipal bonds. Municipal bonds (Munies) are similar to Treasuries. They are, like Treasuries, government-issued. However, instead of being federally backed, munies are issued and backed by a state, city, or county to help fund local projects. Muni bonds may have tax-free advantages for investors.
  • Corporate bonds. There are several different types of corporate bonds. The price and rates such bonds provide depend on factors such as the company’s credit rating and financial stability. Bonds issued by corporations with higher ratings usually pay lower coupon rates.
  • Certificates of deposit (CDs) are fixed-income products issued by financial institutions. CDs are often popular with people within a few years of retirement who have lower risk tolerances. A CD’s maturity is less than five years.

Fixed-index annuities (FIAs) FIAs have grown in popularity over the past few years. Fixed-indexed annuities offer growth potential. You can design these products so they give you a guaranteed income stream to supplement other retirement income you may already have. Money invested in FIA earns interest credits when the underlying index moves upward. One of the most compelling features of a FIA is that it protects from market volatility because it’s not directly exposed to market risk.

Pay lees Taxes

FIAs also give you critical benefits that can help you pay less tax. For instance, unlike 401ks and IRAs, FIAs do not cap your annual contributions. This feature may work well if you are an older individual looking to turbocharge retirement savings in your last few years of work. Or, if you are a high earner, you might choose a FIA if you have maxed out contributions to your 401k or IRA.

A fixed-index annuity can also provide you with tax-deferred growth. Its tax-favored status can help you boost your savings and increase future income. You should note that tax deferral only applies to an annuity funded with money on which you’ve already paid taxes (“non-qualified “money). Unlike other investments, interest earned in a FIA is not taxed until you start withdrawals.

Another practical tax benefit of a fixed annuity is that withdrawals are tax-advantaged. When you take out funds from a traditional 401k, IRA, or another qualified plan, those withdrawals are fully taxable at your income tax rate at the time of withdrawal. Typically, a FIA’s income comes from a combination of interest and return of your original investment. This means that part of that income is non-taxable. You could integrate a FIA with your other taxable withdrawals and potentially lower your overall tax rate once you retire.

Smiling senior couple

Note: Your fixed-index annuity may be subject to federal and state income taxes. If you start your payments before reaching 59½, you could be subject to an IRS penalty. Also, if your annuity has a provision allowing you to withdraw money penalty-free, be sure you don’t exceed that amount. Withdrawals over the free limit are subject to a charge that can result in the loss of your principal. Discuss potential tax issues with your accountant or financial guide before you buy any financial product, including annuities.

Bottom line:

Fixed income, sometimes called “safe money,” is an asset class that is usually less volatile than stocks. Most well-diversified portfolios have at least some allocation to fixed income. This allocation may be more significant as one’s time retirement approaches.

Fixed-income investing generates returns from low-risk, predictable securities. For many conservative investors in or nearing retirement, fixed-income products represent a method of buffering their portfolios against the threat of increasing taxes. Modern fixed-income products, such as annuities, are a highly flexible and tax-favored way to increase your portfolio’s diversity in volatile times. Be sure to check out the 8 Common Mistakes when purchasing an annuity.

Safe money vehicles may be more effective at stabilizing your market risk than other products. Fixed-income products provide steady streams of income over the life of the product. This regular, predictable income allows you to plan more accurately and better know what you can afford to spend once your paychecks stop.

However, although safe money products provide pre-retirees and retirees with many attractive features, they do have a few potential downsides. For this reason, it’s always best to seek sound advice from a reputable retirement income planner. Please get in touch with me if you’d like a second set of eyes to review your portfolio (at no charge). I will be happy to help you make money decisions that align with your values and goals and answer questions you may have.

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