Retirement Planning for the Middle Class part 2

When we think about retirement plans most of us think about IRA’s and 401(k)’s. I love 401(k)’s (especially with a company match) and the ROTH IRA is a great vehicle for retirement savings.  I would like talk about the importance of retirement saving first. It is scary how many Americans have no retirement savings. Many more have a little bit but are not on track to retire comfortably.  The most important thing about retirement savings is simply starting to save and saving every month. You have heard it before, but I cannot stress enough how important the simple act of saving is. If you haven’t started saving, it is not too late. Start now.

Here are some things to keep in mind when deciding what vehicle to use to save for retirement. Remember you should always consult your investment professional and your tax advisor because your situation is unique.

According to a recent Forbes article, about 80% of Americans are in the 10% or 15% tax bracket (or has no tax even before credits). This means a vast majority of Americans are in this situation. To understand how to optimize your retirement savings you need to know if you are one in one of these tax brackets. If you don’t know, ask your tax preparer what your marginal tax bracket is. If you prepare with a tax preparation software, they all have reports that spit out when you print your tax return that will tell you what tax bracket you are in.

Are you in the 10% or 15% bracket?

If you are in one of these tax brackets, there are some special tax rules that apply to you which you may not be aware of. Here it is, are you ready: there is a special 0% tax rate for you on all your long term capital gains and qualified dividends. That’s right, the money you make on your capital investments are largely going to be tax free. This will come into play later as we start to understand our retirement options.

After you have been saving for a while, you there will be a pile of money you will need to put somewhere.  I am a big fan of mutual funds.  Put some in large, mid-size, and small company funds.  The set it and forget it of an index fund works well if you don’t want to think too much about it because your money will do what the market does. Just don’t ever pull money out until retirement and your funds will make money.

I am also a fan of rental real estate if you want to be a landlord. Should you be putting your retirement money in real estate or is that better held outside retirement? To find out it helps to understand the tax aspects of rental real estate. If held outside of retirement, profits from real estate are taxed as ordinary income, but you can deduct any expenses, including repairs, interest and taxes. On top of those deductions you get to depreciate your property, which is basically just writing off the amount you paid for the property over a period of time (27.5 years for residential real estate). All of these combined sometimes trigger a loss for tax purposes even if you are cash flow positive, but you can only deduct these “passive losses” against passive income from other investments you have which may or may not be useful to you in the current year. Long held real estate generally will have income not losses so there will be tax due on this investment. Real estate owned inside of a self directed IRA is taxed as the IRA would otherwise be taxed. In other words the cash distributed from a traditional IRA is still taxed as ordinary income no matter what assets it holds and ROTH IRA’s are tax free no matter what assets they hold.

If you are going to buy real estate with your retirement funds you probably won’t be able to do it with debt so you will need enough in the retirement account to pay for it. (This gives you a goal for your retirement saving if you want to go this route.)  Let’s assume you are buying real estate and mutual funds to save for retirement.  Because of the potential 0% tax on capital gains and dividends as well as ordinary income tax rates for rental real estate, you might want to consider holding the real estate in either a Traditional IRA or ROTH IRA (ROTH is what I prefer). While keeping your ordinary income generating investment in IRA’s, your out-of-retirement investments are well served in long held mutual funds with low turnover.