We had a conversation this week with a younger investor who wants to retire early. While he’s in his 30s now, his goal is to retire in his early 50s—well before the age where he could access his retirement accounts without penalty. His question was whether he should be contributing the maximum amount to his 401(k) or saving his money to an after-tax account like a brokerage or a Roth IRA. While this was a very specific situation, this leads to a broader discussion on the tax diversification of your retirement funds.
First and foremost, you can’t ignore the benefits of investing in your 401(k). With a maximum elective deferral of $19,000 in 2019 for those under the age of 50, it blows away the other tax-deferred options like an IRA that has a maximum contribution of $6,000. But what about brokerage accounts? They have no limit. True, but this is when the math comes into play. Pre-tax savings allow you to save more.
Let’s assume you have a salary of $75,000 and you don’t choose to use your 401(k). After taxes, you bring home $58,500. You put $1,580 a month into your brokerage account. That leaves you with $39,540 to live on. Now if you were to save the $1,580 pre-tax to your 401(k), your taxable income is reduced to $56,040, and your take-home pay is now $43,711—a difference of $4,171. That is nearly 70% of a Roth IRA contribution which would then provide a tax diversification of retirement funds!
Yes, back to tax diversification of funds. When you save every penny pre-tax, you get the significant benefit of tax-deferred growth. However, when you turn 70 ½, the IRS requires you to withdraw those funds. Your $1 million may be more like $750,000 when you consider taxes. Furthermore, we cannot predict what tax rates will be in the future. So, you’ll also want to consider saving to a brokerage account or a Roth account. With a brokerage account, you will only pay taxes on your growth, while with a Roth account, you can potentially access your contributions without penalty or tax.
For a retirement fund withdrawal strategy, we first recommend using taxable funds in your brokerage account. For the past several years, long-term gains have been taxed lower than ordinary income; however, tax rules are apt to change. Then, you move to tax-deferred funds, such as those in your 401(k) or traditional IRA. Last would be funds saved to the Roth IRA. Yes, Roth IRA withdrawals are generally tax-free, and you think it would make sense to take tax-free funds first and delay the tax as long as possible. However, Roth IRAs are not subject to required minimum distributions, so they can grow for multiple generations—another good reason to save your after-tax money into a Roth now while you are in a lower tax bracket than you may be in the future. Decades of tax-free growth will most likely benefit you and your heirs.
Overall, diversifying the tax treatment of your retirement funds is a balance that depends on your situation, current and projected tax rates, and your goals. Furthermore, goals change as life takes you in different directions. While retiring at 50 sounds great at 30, at 48 when you’re at the peak of your career, you may feel differently.
If you have questions regarding the tax diversification of your retirement savings, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166
Disclosures: This article is for demonstrative and academic purposes and 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.
