Benefit tax diversification is an integral part of a well-structured retirement plan. By holding assets in accounts with different tax treatments, such as traditional IRAs, Roth accounts and taxable investments, you can balance current and future tax benefits and gain flexibility to deal with unforeseen circumstances.
The Three Types Of Investment Accounts
Many investors look down on taxable investment benefit accounts because of the taxes they have to pay annually on interest and dividends, as well as any profits that result from the sale. However, such accounts do offer some benefits. First, they are very flexible. There is no limit to the types of investments you can make on a taxable basis. And while traditional and Roth-type retirement accounts are subject to annual contribution limits and penalties for early withdrawal, there are no contributions limits to taxable accounts, and no penalties when you need access to funds before your retirement.
Eligible dividends and capital gains are taxed at a favorable rate in the taxable account (zero for low-income taxpayers, 15 percent for most taxpayers and 23.8 percent for high-income taxpayers). Also, investments sold at a loss can be used to reduce one’s tax liability. Because you can usually control when you sell investments, you can control when you pay most of the tax liability generated by the account. The government again supports taxable investments after the death of the owner. At that time, the cost basis is adjusted to fair market value, and no capital gains tax is payable if the estate sells its holdings immediately.
At first glance, tax-deferred retirement accounts, such as traditional 401(k), traditional IRAs, and similar plans, may seem the most attractive savings options because, by reducing your current tax bill, they give you the greatest up-front benefit. . Since no income is taxed until a withdrawal is made, you may be able to save more overall as the benefits continue to grow.
Unfortunately, savers may pay these tax benefits upfront at a later date. Distributions from tax-deferred accounts are treated as ordinary income, even if the growth in those accounts results from investments that would be taxed at the lower capital gains rate in the taxable accounts. So you will effectively share any gains in your tax-deferred account with the government. If your account grows by 10 percent per year and your tax rate stays the same, your tax liability eventually grows by the same 10 percent. In addition, the Internal Revenue Service generally requires retirees to start taking certain minimum distributions from tax-deferred accounts at age 70 1/2, which can force you to generate taxable income at inconvenient times.
Furthermore, investments in tax-deferred accounts do not receive a basic adjustment when the account holder dies. Beneficiaries must pay income tax when they withdraw assets from this account.
Tax-free or Roth accounts can be hard to beat. While there is no direct tax deduction for contributions to this account, all profits go to investors. The government receives its share in advance, so the eligible current accounts and distributions are never taxed. As a result, $1 million in a Roth account is worth significantly more than $1 million in a tax-deferred account, because the balance in a Roth account can be spent during retirement without paying any taxes. Another benefit of Roth IRAs in particular is that the IRS does not require distributions from them as it does from traditional retirement accounts (though those distributions are required from Roth 401(k)s).
Of course, there are also disadvantages of tax-free accounts. First, funding a Roth account is more difficult. It takes $15,385 of pre-tax income to contribute $10,000 to a Roth account, assuming a tax rate of 35 percent. In addition, there is always the possibility that future legislation may reduce or eliminate the benefits of a Roth account. If, for example, the federal or individual states lowered tax rates or switched to a consumption-based tax system, a Roth IRA would be a poor choice compared to a traditional IRA, because there are no upfront tax benefits.
Choosing Which Account To Fund
A few rules of thumb can help you decide which type of retirement account to use. First, you must have reasonably secure and easily accessible assets in a taxable account as an emergency fund. Six months of living expenses is a good starting point, but the actual amount varies based on your expenses, the security of your current job and how quickly you can land a new job. Funds you need access to before retirement must also be held in a taxable account
If your employer matches your contributions to your retirement plan, you should, whenever possible, contribute enough to get a full match. Any employer matches will automatically be allocated to a tax-deferred account, but you must determine whether the plan will provide a match even if you contribute to a Roth account.
Common wisdom says that you should contribute to a traditional IRA or 401(k), rather than a Roth IRA or 401(k), if your current tax bracket is higher than the tax bracket you expect to occupy in retirement. If the reverse is true, a Roth IRA is the default choice. While these guidelines are a good starting point, savers are generally best served by keeping multiple assets in each account type – which is the idea of tax diversification.
People’s lives and future tax laws are inherently uncertain. Even if you expect your federal tax bracket to stay the same in retirement, it may increase if the overall tax rate rises or if you move to a higher-tax state. There’s no way to know exactly what your situation will be in any given year of your retirement. You must have multiple assets in each account type, but the details of your circumstances will determine their relative size. Like other types of diversification, there is no one-size-fits-all plan.
Going Above And Beyond Retirement Savings Limit
Choosing the best retirement plan for your situation is beyond the scope of this article, but some beneffit planning can allow you to funnel more money into a tax-advantaged account than you might expect.
Some employers offer defined contribution plans with a limit higher than a 401(k), and it is very easy for the self-employed to set up a SEP IRA. For high-income small business owners, it may be beneficial to create a defined benefit (retirement) plan, which can allow for much higher contributions. Certain employers also offer non-qualified savings accounts that allow you to defer income beyond the limits for the eligible plans listed here, but they add a different kind of risk.
In addition to employer-sponsored plans, annuities and life insurance can also offer tax advantages, but most benefit savers should proceed with caution. Annuities provide tax deferral, but lack the up-front tax benefits that make other tax-deferred accounts so attractive. Also, distributions from annuities are taxed at the ordinary income tax rate, so if your tax rate is expected to remain high until retirement, you are effectively allowing the government to take a higher share of your profits than it would in a taxable account.
If your income tax rate is expected to drop substantially in retirement, certain annuities can be an effective savings vehicle once you’ve exhausted your other options. In many cases, the cost of a higher life insurance product outweighs the tax benefits.
If you want to funnel more money into a tax-free account, you might consider converting a portion of your tax-deferred benefiit retirement account to a Roth IRA. You must pay taxes on your income at the time of conversion, but if you expect your tax rate to remain the same or increase in the future, it may be advantageous to transfer some funds to Roth. Lastly, if you plan to use your savings to fund the education costs of a child or grandchild, you may consider funding a Section 529 college savings account. Investments in the account grow tax-deferred, and any distributions used for eligible educational expenses are tax-exempt.
How To Spend Down Retirement Accounts
The order in which assets are withdrawn during Benefit retirement is as important as the choice of which account to fund. By carefully choosing which accounts you withdraw benefit from each year, you can lower the amount of tax you pay.
The first asset you spend usually comes from your taxable account. However, in low-income years, when your income tax rate may be lower, it may make sense to withdraw some funds from a tax-deferred account. In some cases, you can take a taxable distribution without incurring any tax liability at all. Spending from a tax-deferred account may also make sense if your taxable account values highly the securities you plan to hold to death. Run tax projections annually to consider the benefits of withdrawing from a taxable or tax-deferred account.
Aim to keep assets in your Roth account for as long as you can, allowing investments to continue to grow tax-free while you deplete other assets that generate tax liabilities.
For most retirees, no two years will ever look the same. More importantly, there is no way of knowing decades in advance what a person’s tax situation will be during retirement. As with any long-term investment plan, it is important to create a strategy that is flexible and can work even when circumstances change. By taking care to diversify the tax character of your account, you build choices that will allow you to adapt to a variety of financial situations more easily and, ultimately, to save more of the retirement funds you’ve been diligently saving.