(WN): “Don’t let the tax tail wag the investment
dog” is a quirky saying that has been a mainstay for financial advisers for
many years. It means to not let tax issues override smart investment decisions.
However, smart tax planning is essential for smart investing.
The key with tax planning is to be proactive,
and a good place to start is with a tax diversification strategy. I recommend
that my clients have three tax buckets for their investments. This strategy can
lead to tax savings now or in the future, and it also provides flexibility when
taking withdrawals during retirement.
In your 20s, funding your 401(k) might have
sounded like a good goal for your 30s. Now that your 30s are here, you might be
nervously noticing the countless articles on the virtues of investing in your
20s. This isn’t one of those articles. Getting started now gives you plenty of
reasonable paths to build a healthy $1 million by retirement.
Here are five steps to help you achieve that
goal.
Self-employment definitely has an upside. You
have a lot more control over your life when you work for yourself. The
inevitable trade-off is that you lose the perks that many employees take for
granted, like a steady paycheck, paid sick leave, and an employer-sponsored
retirement account to help you someday leave the workplace forever.
I can't help you out with the first two, but
if you're self-employed, then you owe it to yourself to consider opening a
SEP-IRA. These tax-advantaged retirement accounts have the benefits of a 401(k)
and an IRA all wrapped up into one sweet package.
Bucket 1 is for tax-deferred assets, such as
retirement accounts like traditional IRAs, 401(k)s, or 403(b)s. Typically, the
money you invest in a traditional retirement account is deducted from your
income in the year of the contribution. Taxes are not due until the money is
withdrawn, and whatever amount is withdrawn (after age 59½ to avoid a penalty)
is considered taxable income. IRAs have been available since 1974, and are a
common way to save for retirement.
Having all of your invest-ments in Bucket 1
is a wise strategy if you expect your tax rate to be significantly lower in
retirement. However, many people find this is not the case. Income from
pensions and Social Security, combined with the income taxes triggered by
withdrawals from Bucket 1, can keep the tax rate high.
Bucket 2 is for taxable accounts. Many people
do not realize that saving and investing in a taxable account is always wise.
The gains on the investments are not tax-deferred, but they are taxed at a
preferential tax rate on capital gains and qualified dividends. This tax rate
is often 15 percent, but it can be as low as 0 (for people in the 10 percent or
15 percent marginal tax bracket) or as high as 23.8 percent for people with
very high incomes.
Bucket 3 is the newest tax bucket, and it
contains tax-free accounts, such as Roth IRAs and Roth 401(k)s. Roth IRAs only
became available in 1998, and many employers began offering Roth 401(k)s and
Roth 401(b)s. Investors often do not have a Bucket 3. Money invested in these
accounts is not deducted from income in the year of the contribution, so there
are no tax benefits on the front end. However, the beauty of Roth IRAs and Roth
401(k)s is that they provide tax-free growth for the future.
In my view, tax-free growth surpasses
tax-deferred growth (in traditional IRAs and 401(k)s), and I encourage you to
open a Roth IRA or a Roth 401(k) and start funding it. Studies have shown that
millennials are opening Roth IRAs more than any other age group.
***The Benefits***
Why am I encouraging everyone to have three
tax buckets for their investments? The benefits are significant. You can choose
where to withdraw money during retirement. Many investors have most of their
money in tax-deferred IRAs (Bucket 1). Every time they need to take a
withdrawal during retirement, it triggers income taxes.
This is not tax-efficient. The higher taxes
from IRA withdrawals can also cause Social Security benefits to be taxed at a
higher rate, and Medicare Part B (which is withheld from Social Security
benefits) to cost more each month. Drawing from Bucket 2 will trigger capital
gains taxes (only on the gains/not the entire amount withdrawn), but they are
typically less than income taxes. And drawing from Bucket 3 can be tax-free.
Three tax buckets can allow you to delay
drawing Social Security benefits. By starting later, Social Security benefits
accrue and increase. Taxes will be managed (and reduced) by having the variety
of tax buckets, rather than only Bucket 1. Delaying Social Security can also
open a window of opportunity to convert a portion of a traditional IRA to a
Roth IRA during the years after retirement but before starting Social Security.
These years often have a low tax rate, making them attractive for Roth conversions.
Converting a significant amount of a
traditional IRA to a Roth IRA can reduce required withdrawals from the
traditional IRA that must begin at age 70½. Roth IRAs do not have required
minimum distributions, so the money can remain invested in the Roth IRA,
growing tax-free for many years.
Roth IRAs are excellent investment accounts
for teenagers and young adults. Although the gains have limitations as to when
you can access them (which encourages investors to leave them for retirement),
the contributions are always accessible with no penalty or taxes. This makes
the Roth IRA a great option for funding the purchase of a first home or for
college expenses.
Roth IRAs provide estate planning benefits.
When a person inherits a Roth IRA, annual withdrawals are required, but the
withdrawals are tax-free. When a person inherits a traditional IRA, annual
withdrawals are required, but the beneficiary pays income taxes on the
withdrawal.
***The $15,834 Social Security bonus most
retirees completely overlook***
If you're like most Americans, you're a few
years (or more) behind on your retirement savings. But a handful of
little-known "Social Security secrets" could help ensure a boost in
your retirement income. For example: one easy trick could pay you as much as
$15,834 more each year. Once you learn how to maximize your Social Security
benefits, we think you could retire confidently with the peace of mind we're
all after.
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