As you develop your financial plan and retirement strategy, it’s important to consider the probability that some of the variables, such as tax rates, will change in the future. Many of the assumptions that financial advisors use in financial plans can quickly change based on laws and macroeconomic circumstances.
While it’s impossible to predict future tax rates, we are to the point now where I believe, without a doubt, that tax rates are going to increase. To protect your investments and retirement from increasing taxes, consider the following strategies.
Diversify Tax Advantaged Retirement Accounts
Roth IRAs (Individual Retirement Accounts) provide investors with the ability to withdraw funds tax-free. This means that during retirement you can utilize these funds without having to pay income taxes. However keep in mind that Roth IRAs differ from their Traditional counterpart in that you cannot deduct your contributions, only withdraws.
In an environment of increasing income taxes it can become advantageous to pay taxes today at a lower rate, than at an higher rate in the future. In-order to protect your retirement from increasing taxes you should utilize a Roth IRA. However, if taxes stay the same or even decrease in the future placing all of your retirement funds in a Roth IRA would not be the best idea.
Due to the uncertainty of future tax rates, it would best serve investors to diversify their tax advantaged retirement accounts. Depending on your income situation, you can decide to split your investments into both a Traditional and Roth IRA.
This strategy will help you decrease you current tax rate by deducting contributions to the Traditional IRA, while hedging against future tax rate increases by contributing to an Roth IRA on a after-tax basis.
Invest in Municipal Bonds
Buying municipal bonds is a second strategy that you can use to protect your retirement from increasing taxes. Municipal bonds are issued by government agencies below the state level (cities, counties, districts, utilities, etc.). They can be issued for general purposes or to finance specific projects.
The income generated from investing in municipal bonds are exempt from federal and state taxes (only from the issuing state). This makes municipal bonds a great investment for people looking to reduce their tax liabilities.
The best way to take advantage of the tax-free income of municipal bonds is to allocate a modest percent of your bond holdings to this investment vehicle.
Despite the advantages of investing in municipal bonds, there are some risks that investors should be aware of. municipal bonds are still bonds, thus they are susceptible to interest rate and market risk. In addition, I personally believe that municipal bonds have a higher than average default risk.
The use of tax advantaged investments can help protect your retirement from increasing taxes. However remember to diversify as the future is unknown and anything can happen.