We would almost never recommend passing up an opportunity to save tax deferred for retirement. However, it can be advantageous for an investor to have a mix of tax-deferred and tax-free assets in retirement because it can give you flexibility to control your taxes when you’re living on a fixed income.
When investors want to know the best way to invest their money, we generally recommend beginning with your 401(k). Employer-sponsored retirement accounts like 401(k)s, 403(b)s, 457(b)s and SIMPLE plans allow employees to save a considerable amount pre-tax. Furthermore, most employers offer a matching contribution up to a certain amount. This is free money that is given to you for participating.
Next, we generally recommend making Roth IRA contributions. These contributions are made with after-tax dollars, which means contributions do not help you today, but they grow tax free, and earnings can be withdrawn tax-free in retirement. If you are above the income limits to contribute to a Roth, we then recommend maxing out your 401(k) because it lowers your taxable income today. Once you’ve done that, we recommend saving outside either in a brokerage account or a non-deductible IRA. The problem is that very few people have enough to do both; therefore, many investors’ retirement assets end up in tax-deferred accounts.
While it is generally good to kick the tax can down the road, tax-deferred retirement assets can become more of a burden than you think. Imagine an investor who has nearly all of his money in his 401(k). When he retires, he begins to withdraw enough to cover the difference between Social Security and his spending. Because he and his wife were good savers and not extravagant spenders, he only pulls out what they need to live comfortably, keeping the couple in the 25% tax bracket. Fast forward a few years to when the investor must begin withdrawing required minimum distributions at 70 ½. Now he is required to withdraw nearly twice as much, which bumps them into the 33% tax bracket.
The reality is, there is no one solution that works for every situation. There are plenty of investors who save the bulk of their assets tax-deferred, and end up being in a lower tax bracket in retirement. However, you can only make decisions on what you know today, not speculation of what tax rates may be in the future. When there is uncertainty ahead, your best defense is diversification. You may consider contributing only up to the employer match to your 401(k) and then directing funds to a Roth IRA, convert funds from an IRA to a Roth, or utilizing your company plan’s Roth 401(k) option. Investments that are outside of a retirement account are also made with after-tax dollars, but they can be moved and used free of tax consequences. Income earned on your investments will be taxable but withdrawals of your principal are not.
At Henssler Financial, we believe this is an area investors can best benefit from professional advice. Investors are generally too emotional about their money. They are often afraid to sell investments because of fear of owing taxes, but you cannot use an appreciated stock certificate to buy food at the store or use it to pay your bills. A trusted financial adviser should begin looking at your retirement tax situation at least 10 years prior to retirement and should recommend changes you can make to ease your tax burden.
If you have questions about diversifying the tax treatment of your retirement portfolio, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
