Planning for your retirement is one of the most important things you’ll ever do. However, some people overlook an opportunity in the form of diversities. Yes, this is great for your investment portfolio, but it’s also beneficial for retirement. You would diversify not just how you save but also the taxes you’d pay.
When planning for retirement, you want to focus on your savings but also your pension, Social Security, nonretirement investments, and other income sources. Since current tax rates are pretty low from a historical viewpoint, you can anticipate they’ll either increase or decrease when you retire.
Even with this unknown factor, you can still plan for a positive tax outcome. One possibility that’ll give you more control of taxable income when retiring consists of using different tax treatments for your various accounts.
Four Key Considerations
For the most part, you can choose between four account types, each with individual benefits.
Typically, this includes the 401(k), traditional IRA, and 403(b). Overall, these lower your taxable income in the year you contribute. With these accounts, you probably wouldn’t get taxed for pre-tax contributions and gains until retirement. Then, you’d have to pay regular income tax rates on withdrawals.
For these accounts, you have to withdraw the required minimum distributions (RMDs) annually from your tax-deferred savings. This starts when you reach 70.5 years of age or 72 if you turn 70.5 after 2019.
After-tax dollars fund brokerage and traditional bank accounts. So, for brokerage accounts, you can contribute or withdraw money and sell securities for any purpose whenever you want without penalty. Also, you’re taxed for any taxable investment income in the year earned.
Additionally, the IRS can tax you for capital gains on investments that you sell for a profit. Now, if you sell at a loss, there’s a chance you could use that to offset capital gains as standard income or up to $3,000. One last thing, these accounts aren’t subject to RMDs.
- Roth IRA/401(k)
Since after-tax dollars fund both a Roth IRA and Roth 401(k), your current taxable income won’t decrease. If you withdraw funds after retirement, you won’t pay tax on income, appreciation, or withdrawals. While a Roth IRA isn’t subject to RMDs, a Roth 401(k) is. You can avoid this by turning it into a Roth IRA at the time of retirement.
You can also think about converting a traditional IRA into a Roth IRA. Sometimes it’s difficult to know whether or not a Roth IRA conversion makes sense, but there are some calculators out there that can help. You can use software like the WealthTrace Planner to run Roth conversion scenarios. The outputs will show you how much you can save on taxes if you do the conversion over various years.
- Health Savings
If your employer offers a health savings account and you have a high-deductible health plan, this would help you save money. For this, contributions would lower your taxable income up to the yearly limits. This kind of savings isn’t subject to RMDs.
Also, this investment grows tax-free, and if you withdraw funds for medical expenses, you don’t pay tax. However, when you reach 65 years of age, any withdrawals for non-medical reasons get taxed as regular income.
What’s Right for You?
To answer this, you have to consider several factors like your tax rate at retirement, your current marginal tax rate, and the level of flexibility you prefer when it comes to withdrawals. At a minimum, factor in the following:
- Matched Contributions – If your employer matches contributions, make sure you save enough to take advantage of this since it’s free money.
- Health Savings Account – Although the rules might change, an individual can currently contribute as much as $3,550, while a family can contribute up to $7,100. Also, anyone 55 and older can contribute an extra $1,000. Sometimes, employers match these contributions, as well.
- Maximize Tax Advantages – Identify the right combination of tax-deferred and Roth accounts based primarily on your current tax bracket.
- Higher Tax Bracket – Since your tax rate will probably remain the same or decrease at retirement, this is when you should maximize tax-deferred accounts.
- Middle tax bracket – Consider splitting your savings between a Roth and tax-deferred account. With unpredictable future tax rates, this is an excellent way to alleviate some of the uncertainty.
- Lower tax bracket – Max out your Roth account preferably, while you’re still in a lower tax bracket.
Brokerage Account – If you still have funds to contribute, you might want to invest in a traditional brokerage account. By holding appreciated investments for more than 12 months, you can take advantage of long-term capital gains rates. Other options include index mutual funds, exchange-traded funds, and tax-managed funds, which don’t produce as many taxable distributions. Especially if you’re in a higher tax bracket, tax-advantaged municipal bonds prove beneficial.
Roth Conversion – If your income prevents you from contributing to a Roth IRA, consider a Roth conversion, which entails converting a portion of or all of a traditional IRA to a Roth IRA. Although you’d pay standard income taxes on the converted amount in the same year you contributed, this helps diversify a portfolio comprised mostly of tax-deferred accounts.
It’s hard to determine future tax rates. However, with these four types of accounts, you benefit from having flexibility and gaining better control of future tax bills. Second, you have to pay standard income tax for tax-deferred withdrawals. If you take money out before age 59.5, the IRS could slap you with a 10 percent penalty. But after that age, you don’t pay taxes on Roth withdrawals as long as you’ve owned the account for at least five years.
To enjoy your golden years from a monetary standpoint, you want to invest in the right accounts and avoid taxes and penalties as much as possible. If you feel confused or overwhelmed, sit down with a professional financial advisor who can answer questions and provide needed guidance for the best retirement possible.