When saving for retirement, the typical advice is to max out your 401(k) or individual retirement account (IRA) before anything else, but this is not always the best strategy. The problem comes with taxation in retirement. When you have only one type of retirement account, you get backed into a certain tax structure, which can prove quite detrimental. A better strategy for some retirement savers may be to split their money among a variety of accounts, including Roth and brokerage options. This provides different strategies for dealing with various retirement circumstances and can lead to significant tax savings. When all of your money is in tax-deferred accounts, you will always need to pay taxes on withdrawals when rates may be much higher. Having other options is key to minimizing tax payments.
The Problem with Tax-Deferred Retirement Accounts
To understand the trap of investing in only 401(k)s and IRAs, consider the fact that withdrawals from these accounts are taxed as ordinary income, and these rates are generally higher than long-term capital gains taxes from brokerage accounts. The idea of a tax-deferred account is beneficial in terms of compounding interest, but you also accept the risk of not knowing tax rates in the future. There are many accounts in which the additional gains from tax-deferred investments do not balance out the increase in taxes paid. However, this very much depends on the tax bracket you are in when you are saving for retirement and the one in which you exist as a retiree.
Tax brackets and income levels are important for more than just taxes, too. At age 73, people must begin taking annual required minimum distributions from their tax-deferred accounts and pay taxes on the withdrawals. These distributions are required regardless of need and may increase your income enough to push you into new tax brackets while also increasing Medicare premiums and causing a higher tax rate on Social Security benefits. Furthermore, it is important to remember that IRAs can be inherited and thus you may pass the tax burden on to beneficiaries other than your spouse. People who inherit IRAs (other than a spouse) typically need to liquidate the accounts within 10 years and annual minimum distributions may be required. If these come during the peak earning years of the beneficiaries who inherit the IRA from you, that could become quite problematic, and a lot of the accumulated money can be lost to taxes. Roth conversions before, or even after the RMD age of 73 can be beneficial for the IRA owner, and would definitely improve the legacy for the beneficiaries, who would be receiving tax free funds in an inherited ROTH IRA.
The Other Types of Account That Investors Might Consider
Luckily, there are options to help diversify tax options in retirement. For example, you could invest in Roth accounts, which are funded with after-tax money. Thus, you can make withdrawals without paying taxes provided that you are at least 59.5 years old and have not contributed to the account in five years. Furthermore, Roth accounts do not come with required minimum distributions. Beneficiaries who receive the Roth account will need to liquidate within 10 years, but they have the benefit of letting it grow until the 10th year and can then take out one large distribution. Furthermore, these beneficiaries do not need to pay taxes when they make a withdrawal.
Another option is a brokerage account, which has no requirement in terms of minimum distributions. Furthermore, as long as you’ve held an investment for at least one year, withdrawals are taxed as long-term capital gains. While rates depend on your income level, they are typically less than income tax rates, which can be as high as 37 percent. Long-term capital gains taxes do not increase past 20 percent. When these accounts are inherited, they get a step-up in basis, which means that the account gets adjusted according to current market value at the time of death of the owner. Provided that the beneficiary liquidates the account immediately, there are no capital gains taxes due.
A third option that people planning for retirement may want to consider is a health savings account, which is filled with pre-tax money. People with a high-deductible health plan have access to these accounts, which can be used to pay for qualified health expenses. Importantly, this account can also be used as a retirement savings tool, as your assets will grow over time. Money from this account can be withdrawn to cover medical expenses without paying taxes. Unlike a tax-deferred account, a health savings account never requires that you pay taxes provided that funds are used to pay for healthcare costs.
Furthermore, taxes never need to be paid as long as the money goes for earmarked purposes. The downside of these accounts is that beneficiaries need to liquidate the fund and pay income tax in the same year that the owner dies.
Using Life Insurance as a Wealth Management Tool
Finally, investors can use cash value life insurance policies as a secure and conservative tax free vehicle for retirement as well. In addition to the large tax free death benefit that naturally is built into all types of life insurance policies, certain types of cash value policies allow for the owner to take regularly occurring tax free intentional “loans”, as a supplemental income stream in retirement, if the policy has been in place for 10-15 years or more, and has built up sufficient cash reserves ( such that the loans would not cause the policy to lapse or struggle at all). Also, importantly, many of the newer life policies come with long term health care or “chronic illness” riders that allow the owner to accelerate all or a large part of the death benefit, on a tax free basis, for the purposes of addressing or paying for costs associated with a long term care event. This can enable the policy owner to preserve all or more of the rest of their estate for loved ones, even in the event of an expensive or prolonged chronic illness situation in old age.
How to Divide up Retirement Funds Among Different Accounts
The first rule when it comes to retirement accounts is to completely fund a match from your employer—i.e. “free money”. Since this is a guaranteed and offers an incredible rate of return, be sure to maximize this benefit. Beyond that, the breakdown really depends on your income. As a general rule of thumb, some experts have been advising to put half of your retirement savings in tax-deferred accounts, a quarter in Roth accounts, and the final quarter in brokerage accounts, or life insurance . The amount you put into a health savings account depends on your expected medical expenses in retirement. Remember that not everyone will have access to this kind of account depending on their healthcare plan.