Instead of waiting to plan for your retirement, start now. Diversification is one option. If you’re already putting money aside, you should diversify how and when your savings get taxed. Making the right decision can benefit you while maneuvering your way through two specific unknowns associated with retirement. Those include:
- Taxable Amount – When determining the amount of taxes deducted from your income, you want to think beyond retirement savings. Also, factor in any pensions, Social Security, non-retirement investments, and other income streams.
- Post Tax Rate – You need to know the tax rate you’ll pay once you retire. Currently, post-tax rates are quite low. However, there’s always the possibility they could increase before or after you retire.
By strategizing around these two unknowns, you can enjoy a better tax result. One way to gain better control over taxable income once you retire is to use accounts with different tax treatments.
Four Account Types
Each of these account types offers unique benefits.
- Tax-deferred – Contributions to these accounts come from sources like 403(b) accounts, traditional IRAs, and 401(k) accounts. With this type of account, taxable income within the year contributed typically decreases. Also, there are no taxes on gains and pre-tax contributions until you’ve retired. At that point, regular income tax rates generally apply to withdrawals. Keep in mind that you can’t leave money sitting in a taxable-deferred account forever. Either at age 70.5 or 72, if you turn 70.5 after 2019, you have to take the RMDs or required minimum distributions annually.
- Taxable – After-tax dollars fund these traditional brokerage and bank accounts. If you have a brokerage account, you’re allowed to withdraw money, sell securities, and contribute funds whenever and for whatever reason you want without penalty. Also, taxes apply to any taxable investment income within the year earned, and you’d have to pay capital gains taxes if you sell investments for a profit. Now, if you take a loss on an investment sale, you could use it to offset gains in some instances. This also applies to ordinary income up to $3,000. One final note, taxable retirement accounts are exempt from RMDs.
- Roth IRA – After-tax dollars contribute to Roth IRA and Roth 401(k) accounts, which differs from tax-deferred accounts. Therefore, your current taxable income doesn’t decrease. However, when withdrawing funds as a retiree, you wouldn’t pay taxes on income, withdrawals, or appreciation. One distinct difference between the two Roth options is that while an IRA is exempt from RMDs, a 401(k) isn’t. Now, to avoid RMDs, you can roll a Roth 401(k) into a Roth IRA upon retirement.
- Health Savings – Although health savings accounts or HSAs aren’t the same as retirement accounts, they’re often beneficial. If your employer offers this and you have a health plan with a high deductible, maintaining an HSA is a highly effective way to save for retirement. The reason is taxable income decreases up to yearly limits whenever you make a contribution. An HSA is also a great way to grow your investments tax-free and avoid paying taxes on withdrawals for certain medical expenses. Remember that at age 65, withdrawals made for nonmedical reasons get taxed as regular income. As for RMDs, these accounts are exempt.
Selecting the Right Mix of Accounts
You want to consider several things when choosing different retirement accounts. For example, factor in your tax rate in retirement, your current marginal tax rate, and the level of flexibility you want on withdrawals. To make the selection process easier, consider these guidelines.
- HSA – Medical expenses typically increase as people age. A single person can currently contribute as much as $3,550, while families can contribute up to $7,100. Anyone 55 years of age and older can contribute an additional $1,000. Check with your employer to see if the company offers matching contributions. After all, that’s free money.
- Matching Opportunities – Many companies match contributions that employees make to a retirement account. The goal is to save enough money, so you get a 100 percent match.
- Brokerage Account – If you have additional funds to invest for your retirement, think about a traditional brokerage account. Although taxable, options exist to improve tax efficiency. Some of these include:
- Choosing tax-advantaged municipal bonds. This is particularly beneficial if you fall in a higher tax bracket.
- Hanging onto appreciated investments for longer than a year to get long-term capital gains rates.
- Consider different tax-efficient investments such as index mutual funds, tax-managed funds, and exchange-traded funds.
- Maximize Tax-advantaged Savings – Based primarily on your current tax bracket, you might want to consider a combination of Roth and tax-deferred accounts. For instance, if you’re in a lower tax bracket, you could max out your Roth accounts. If you’re in a middle tax bracket, you could split your retirement savings between Roth and tax-deferred accounts. If you’re in the highest tax bracket, consider maximizing your tax-deferred accounts.
- Roth Conversion – If you’re unable to contribute to a Roth IRA due to your income, there’s always a Roth conversion. This entails converting all or a portion of the money coming from a traditional IRA to a Roth IRA. To do this, you’d pay standard income taxes but only on the amount converted and within the same year of the conversion.
It is not easy to find good calculators that show you whether or not you should consider a Roth conversion. There is one good retirement planning application named WealthTrace that has really good Roth conversion scenarios. Using this software you can see the difference in taxes you will pay over your lifetime if you convert vs. not converting to a Roth IRA.
Seek Professional Assistance
Trying to anticipate tax rates down the road is challenging. However, with different account types, you have a lot of flexibility and a good degree of control as to your financial standing when you retire. Since there are many considerations, you might want to sit down with a reputable financial advisor who can help you achieve the best possible outcome for your golden years.