As we start part three of this series on how to reduce your taxes in retirement, we are going to be covering municipal bonds, LLCs for real estate, retirement plans, and qualified charitable distributions. We begin with a discussion on municipal bonds.
Municipal bonds are debt securities that are issued by local state governments like city and county governments. The thing that makes municipal bonds interesting is that they are not taxed by the federal government, which is, of course, the largest amount of tax that we pay. Another great thing about municipal bonds is that if a municipal bond is purchase from the state in which you live in, it is not taxed at the state level. Some states, of course, do not have state-income tax to begin with.
However, for those people in the highest brackets, when you can buy an investment where you are not taxed at the state or federal level, it really makes the tax equivalent yield very competitive with most of any other types of investment grade bonds that are available.
Let’s say a municipal bond yielded 1.5% and your family’s marginal tax rate is 32% and your state income tax is 5%. If you buy a bond in your state, the tax equivalent yield would be 2.38% or 2.21% if the bond were from a different state’s municipality than your own. We commonly use municipal bonds inside of our clients' taxable accounts where it is going to produce a higher tax equivalent yield for them than what we would see from investment grade bonds. Because Municipal bonds pay less than investment grade corporate bonds on average, it is imperative for our clients and for you to be in the higher tax brackets in order to experience a higher tax equivalent yield.
Now, if you are comparing municipal bonds to treasury bonds, treasury bonds have a lower yield than municipal bonds. If your main focus is just strictly yield and not diversification, safety or capital preservation, then municipal bonds will almost always have a higher yield than treasury bonds. Treasury bonds are considered to be the safest bonds in the world because they are issued and backed by the full faith of The United States Government. One of the great things about treasury bonds, although that is not what this article is about, is that they have a slightly negative correlation to the US and global stock markets, which offers investors wonderful diversification. However, treasuries have the lowest yield. This article is discussing specifically municipal bonds and the tax advantages that they offer you, the investor, inside of your taxable accounts.
LLC for Real Estate
One of the benefits of having an LLC and putting property or rental property inside of it, is the pass-through of the income to your own personal tax return. The LLC itself does not have to pay taxes, so you avoid double taxation. You can pass the income straight through to yourself, and you can pay the taxes on whatever you are actually paid. The other nice thing about an LLC is it gives you the flexibility to identify as an S corporation or a C corporation.
By identifying as either an S corporation or a C corporation, you are able avoid having to pay self-employment taxes, which can be quite expensive. If you have ever run a business with self-employed income, you know that when your income is below a certain threshold ($142,800 in 2021) self-employment taxes are 15.3% or up to $21,848.
So identifying as an S corporation in order to avoid self-employment taxes is another big benefit of setting up an LLC to hold your rental properties.
We would also benefit with reducing liability by putting your property inside of an LLC, but we will not get into that in this particular article.
As you continue to produce income on your rental properties, you are also able to use depreciation with an LLC, which the government forces you to take anyway at the end if you do not take it during the time in which you own your investment real estate. This gives you yet another deduction inside of the LLC, which will also reduce the amount of income that you are required to report on your personal tax return. All these are things to discuss with your CPA or accountant, and they can give you more details as you move forward with having your rental property inside of an LLC. This is what we do for most of all our clients in order to help them reduce their taxes during retirement, if they already own rental property.
The next tax saving idea that you can implement during retirement, if you own a small business (could be your LLC with rental property), is to set up a retirement plan.
There are several options out there that I want to discuss in this article, which will be the self-employed 401(k), the SEP-IRA, and the SIMPLE .
The self-employed 401(k) is for an individual business owner that has no employees other than maybe a spouse. It has the same rules where you cannot take withdrawals before age 59 ½ unless it is for a disability or some sort of emergency triggering event that they have already listed in the laws. The nice thing is that you are allowed to contribute up to 25% of your compensation up to a maximum of $58,000. Let's say the business is producing $100,000 of income for the owner, that means you can contribute $25,000 to your self-employed 401(k). It is a nice way to do it. They now have self-employed 401(k)s that have little or no administrative costs at large custodians like Schwab and Fidelity. And it really gives an opportunity to sock away up to $58,000 if you do not need to live off of the income. If you had a business where you were paying yourself $232,000 in 2021 and you wanted to contribute 25% that would take you up to the max of $58,000, for example. And that is a substantial amount of money to be able to save and deduct from your taxes and then have it grow tax deferred.
The next retirement savings vehicle that you can use in retirement to help lower your taxes is the SEP-IRA. This one is really easy to set up, it has got really flexible annual funding requirements, your contributions can vary between 0% and 25% of your compensation up to a maximum of $58,000 in 2021. And the issue is that each employee must receive the same percentage of contributions from the company. You want to be careful with how many employees you have. The more you want to put into a SEP-IRA it is probably better for a self-employed person to use the self-employed 401(k). Because if your contributions are a big percentage of your income you are going to have to match that percentage with your employees which may make your plan too expensive. It has all the same rules that a normal retirement plan would have, or a normal IRA would have.
The final thing that we are going to discuss is a SIMPLE IRA. So, this is for businesses with 100 or fewer employees. It is the same as the 10% withdrawal penalty if you are before 59 ½, nothing different there. There is, however, less administration. The contributions are funded by the employer contributions of elective employed salaries. There is a mandatory 3% matching contribution on a SIMPLE IRA or a 2% non-elective contribution with the SIMPLE IRA. Now as far as the participants go (the people that are putting money into it) the great news is you can put up to 100% of your compensation with a maximum of $13,500 in 2021. There is also a catch-up provision for those 50 and older of $3,000. So, if you had a side business at age 51 that was making $20,000 and you were the only person there, maybe you and your spouse, and you were able to set up a SIMPLE IRA you could defer $16,500. If you and your spouse were employees of ages 51 and the profit was, say $35,000, you could end up contributing $16,500 for each of you which of course would be $33,000 or close to 100% of the profit. These are great retirement saving vehicles for businesses holding rental real estate. If your rental properties are producing $27,000 or less of income that is passing through to your taxes you can go ahead and instead of doing that take the money and put it into a SIMPLE IRA and deduct that from your income that year rather than spending it and having to pay the full income tax on it at your marginal (highest) tax rate. The thing I like about the SIMPLE IRA is that you can contribute 100% of your income. It is exceptionally good to use with businesses that are not your full-time job, if you have a full-time job you and your spouse has a full-time family income where you can pay all of your living expenses, and then you have this side business over here saving money into the SIMPLE.
Qualified Charitable Distributions (QCDs for RMDs)
The final way to save and reduce your taxes during retirement that we are going to discuss in this article is what are called qualified charitable distributions or QCDs.
For those of you that give to charities on a regular basis and every year, particularly if you are bunching them together for years to make sure you get above the standard deduction, the qualified charitable distribution from your retirement plan account, usually IRAs, gives you a great opportunity to reduce your taxes.
Rather than making the required minimum distribution (RMD) to yourself from an IRA, make a qualified charitable distribution or QCD directly to a charity. And instead of the money counting as income at your marginal rate, which is also known as your highest tax rate, it counts as a deduction if, of course, you can get it above your standard deduction under our new tax reform laws discussed in Parts 1 and 2 of this series. Now, in order to qualify, you have to make sure that the distribution from your IRA goes directly from the IRA to a 501(c)(3) charity of your choice. Also, you may not give above $100,000 in a year and that includes all your IRA RMDs and all the different charities combined. It must be less than $100,000 in one year. Also, in order to qualify it needs to be at, or below the RMD level for that year. So in other words, you cannot do a qualified charitable distribution or QCD directly to a ministry and deduct it if you give more than what your required minimum distribution is for the year.
For those of you that are giving to ministries out of your taxable accounts, your checking accounts and your savings accounts or any other type of money that is sitting in taxable accounts, for you to make a move like this and not realize your required minimum distribution as income but rather as a deduction, this is a huge improvement to your tax situation even if you do not go above the Standard Deduction. If you do go above, it is even better. It is a reversal of what was going to come to you as income is now going to come to your tax return as a deduction (itemized) if you are above the standard deduction. This particular strategy is one that we use every single year, and I like it very much, and it is particularly effective for those people that are giving to charities with their taxable money, have RMDs, and that they are also at a higher tax bracket.
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If you want, set up a 20 minute call with Thomas Cloud, Jr., CFP(R) to discuss how you may be able to lower your taxes in retirement using municipal bonds, LLCs for real estate investment properties, QCDs, or retirement plans for small businesses then click here and schedule it now: https://calendly.com/thomascloud/retirement-ready-success-call. There is no cost or obligation. Also I encourage you to watch my free retirement video: https://go.thirdactretirement.com/strategy.