Let’s dive into the different ways you can diversity taxes in retirement, and why you want tax diversity in your retirement portfolio.
401(k)s:
Already sounds scary, right? 401(k)s were created in November 1978 and made sense at the time given that the highest tax rate was 70%. You might ask, why? Well, a 401(k) enables you to make pre-tax contributions and to grow the account tax deferred. So contributions to a 401(k) reduce current-year taxable income, and you don’t pay taxes on the account until you start to withdraw funds from the account. Fast forward to today where the highest tax rate is 37% and there is strong confidence that tax rates will go up soon, maybe even dramatically. And many people are retiring with just as much income, if not more, than in their working years. The idea was that retirees would have significantly less income in retirement, and therefore lower taxes in retirement. Before you start converting your money in a 401(k) to a more tax-friendly account (yes, I am referring to a Roth IRA), keep these points in mind:
You must be at least 59 ½ years old to withdraw funds from your 401(k) without incurring a 10% penalty on the money withdrawn in addition to paying taxes on the amount withdrawn.
If you are not 59 ½ years old, you must come up with the money to pay the taxes on the amount converted from a 401(k) to a Roth IRA as you will have to pay taxes on the converted amount at the time of conversion.
You want taxable money in retirement. Otherwise, you are giving up a freebie that the IRS gives you every year, and it is called the standard deduction.
What is most important to you – paying higher taxes now or paying higher taxes in retirement? This might be a simple question in your mind, but if your current income is high, might not be as easy of an answer as you think. Giving up that tax deduction from making contributions to your 401(k) could result in higher taxes in the current year.
Now let’s not forget the employer match in a 401(k)! If you are financially capable of contributing the amount need to receive the full employer match, you should be doing it! Every year…. It is free money! And free money puts any tax conversation on that free money on the back burner.
Traditional IRAs:
I won’t spend too much time on Traditional IRAs as most are treated in the same manner as a 401(k) from a tax perspective. The only difference is that you can contribute both pre-tax and after-tax moneys to a Traditional IRA. Gets interesting converting a Traditional IRA to a Roth IRA when there are pre-tax and after-tax moneys in the account…. Not as simple as you may think.
Brokerage, Savings, and Interest-Bearing Checking Accounts:
For these types of accounts, you only contribute after-tax moneys to the account. Then, you pay ordinary income taxes on interest and dividend income annually and capital gains tax annually, if applicable, on securities held in the account. At the time of withdrawal of moneys from the account, you pay capital gains taxes for securities sold and any remaining dividend and/or interest income not previously taxed on the securities sold. So instead of paying taxes only at the beginning (Roth IRAs) or only at the end (401(k)s) of the hold period, you pay taxes throughout the hold period, thereby streamlining taxes paid on your account over many years. Very beneficial in diversifying your taxes in retirement and a great strategy for managing current year taxes if the accounts have a large balance.
Health Savings Accounts (HSAs):
Surprise, surprise, this is one of the most tax advantaged retirement accounts you can own. And you probably thought it was the Roth IRA. Employers can provide HSAs along with a high deductible health insurance plan. I see so many clients pass on opportunities for an HSA because they do not understand the tax benefits. Here’s why they are beneficial for your retirement portfolio. Pre-tax contributions, potential employer matching contributions, tax deferred growth, tax-free distributions if for medical expenses prior to the age of 65 and tax-free distributions for any purpose after the age of 65!!! Problem is that many of the HSAs are only interest-bearing vehicles versus investing in the market. So there is not a lot of growth in the HSA account over the years.
Roth IRAs and Roth 401(k)s:
Why are Roth IRAs so beneficial? After-tax contributions into the account, and if setup in accordance with the IRS guidelines, you pay no additional taxes on the account. None, no matter the growth in the account during the hold period. So, the account is not impacted by future increases in the tax rate. Per IRS guidelines, you must hold the account for a minimum of five years to take advantage of the tax benefits on the growth of the account. And to avoid an imposed 10% penalty, you cannot withdraw earnings from the account before the age of 59 ½. Now you can withdraw contributions from the account at any time without penalty or taxes.
There is also an income limitation for contributing to Roth IRAs, which rules many people ineligible to contribute to a Roth IRA. That’s where Roth IRA conversions become invaluable for those whose income is too high but still want the tax benefits of a Roth IRA to avoid paying high taxes in retirement. Note that the five-year clock applies for Roth conversions in the year of conversion prior to the age of 59 ½. Also, there is a balance between paying taxes today and taxes in retirement, and there are benefits to having taxable income, even in retirement.
Why choose one type of retirement account? Why not have all of them in your retirement portfolio? There are pros and cons to each, and the right combination for you not only depends on your preferences but also on your unique financial situation.
Now I have oversimplified this discussion to give you an idea of how you can diversify to mitigate taxes in retirement. Trust me, there are professionals who make a living off answering tax code questions on IRAs, and they have a very lucrative business. Which means, this is a complex topic.
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All information provided by Hartmann CFO, LLC and Healthy in Retirement is intended for informational purposes only. The views expressed are personal opinions and should not be construed as financial or tax advice for your specific situation. Please make sure to do your own research or find a trusted financial professional, tax adviser or attorney before making any financial decision on your own.
Neither Hartmann CFO, LLC, Healthy in Retirement nor its owners make any representations as to the accuracy or suitability of the claims made here. Nor does Hartmann CFO, LLC, Healthy in Retirement, or its owners assume any liability regarding financial results based on the use of information provided here.