You know it’s important to put money aside consistently for retirement during your working years. But you may not be aware of the value of saving in different retirement account “buckets” so you won’t be hit with a tax bill that’s larger than it needs to be when you start withdrawing your savings.
We asked Jarrett Topel, a financial advisor in Berkeley, California, about strategies for structuring retirement accounts with taxes in mind.
What should people know about retirement savings and taxes?
Many people feel they’re being penalized when they take money out of these plans and see the tax bill they’ll have to pay, but this is not at all the case. The government has waited patiently for many years to tax these dollars; it’s simply getting what it would have received many years prior if you had not received a tax benefit in the first place (i.e., if you did not contribute). In the meantime, you’ve had a chance to let your money grow, tax-deferred, and take advantage of compounding interest, sometimes over decades.
You may begin taking money from these plans at age 59½ (and in some cases as early as 55). At age 70½, in most cases, you must start taking a certain amount of money from these accounts every year — this is called a Required Minimum Distribution.What withdrawal strategy will minimize taxes in retirement?
Your withdrawal strategy will have a major impact on your income tax bracket and ultimate tax bill. This is why tax diversification is so important. Having money in a combination of qualified accounts, tax-free accounts and nonqualified accounts will allow you to manage your overall tax obligation when it comes time to withdraw in retirement.
- Currently, money that comes out of “qualified” accounts (such as IRAs, 401(k)s and 403(b)s), is taxed at ordinary marginal income tax rates, which range from 15% to 39.6% for most people.
- Money that is withdrawn after being held for at least a year in “nonqualified” accounts (such as personal savings and investment accounts) is taxed at capital gains rates, currently 15% — on gains only — for most investors.
- Money that comes out of Roth IRAs comes out tax-free, because you already paid taxes on it before you contributed to the account.
So, let’s say you have income from Social Security and a pension; that income puts you in a certain tax bracket. Now you need to take $50,000 from your investment portfolio, and you want to figure out the right mix of funds for the best tax outcome.
One way to optimize your withdrawal is to take just enough from the qualified account so that, combined with your Social Security and pension income, it keeps you in the same tax bracket. This is a smart strategy because it minimizes the amount of tax you’ll pay on the most heavily taxed source of funds.
Then you take the remainder partly from your nonqualified account (15% tax on just the gains, if held for more than one year), and partly from your Roth IRA, tax-free.
In this scenario, you were able to get the money you needed, without moving into the next, higher tax bracket, and by paying tax rates that ranged from 0% to your marginal tax rate.
By contrast, ifall of your money is in qualified accounts (as it is with most people), you’ll have no options — you must simply pay at whatever marginal tax bracket you happen to be when you make the withdrawals.
Since we have no idea what tax rates will be in the future, there’s no way to tell what type of account (qualified, nonqualified or tax-free) will be most advantageous in the long run. So, as with so many things in life, the key here is diversification. If you have money in each type of account, you’ll have flexibility in your withdrawal strategies to contend with whatever the laws and associated tax rates are at that time.
That said, don’t let the tax-tail wag the investment-dog. Minimizing taxes is an important part of an overall comprehensive financial plan and withdrawal strategy. However, paying taxes is not a bad thing in and of itself, and should not be the primary reason you make investment decisions. We’veseen clients whohave spent years accumulating the money they need for retirement, and then because of the tax obligation due at the time of withdrawal, they’re hesitant to spend the money they have in these accounts, even when they can afford to do so.
Remember, paying taxes simply means that you made money. The only way to truly avoid paying taxes is to avoid making money, and that is not in anyone’s best interest.
The article Why Your Retirement Accounts Need Tax Diversification originally appeared on NerdWallet.