During their working years, many people focus only on what they are saving and how it impacts their tax situation in the moment. They are looking for the biggest tax break today, while not fully considering what things may look like tomorrow. We believe in also focusing on how you are saving and having three distinct buckets of money – tax-deferred, taxable, and tax-free. This Power of Three strategy will provide tax diversification in retirement, allow for more annual planning opportunities, and may lower your lifetime tax bill.
1. Tax-Deferred
This bucket includes i401(k)s, 401(k)s, 403(b)s, 457s, and IRAs. When you fund these types of accounts, pre-tax contributions are deducted from your taxable income today, investments grow tax-deferred, and you pay ordinary income tax only when you withdraw the funds in the future. This is a great way to save on taxes during your high-earning years. Also, by deferring the taxes, you start with a larger base investment amount on which the funds will grow. However, these accounts have annual funding limits, deduction restrictions, and will eventually have annually required minimum distributions. Withdrawals will also be taxed at unknown future rates, and this retirement income could have an impact on your Medicare premiums and Social Security taxation.
2. Taxable
This bucket includes brokerage and revocable trust accounts, which are funded with after-tax dollars. Because you receive no tax benefit on the contributed dollars, you only pay tax on gains and income. There are no annual contribution limits, no early withdrawal penalties, and long-term capital gains and qualified dividends currently have favorable tax rates of 0%, 15%, or 20%. While there may be ongoing tax liability on these types of accounts, they provide a useful source of liquidity with the ability to strategize how funds are raised for cash needs. At death, the investments in these accounts receive a step-up in basis for your heirs.
3. Tax-Free
This bucket includes employer-sponsored retirement plans with a Roth option and Roth IRAs. Like taxable accounts, these accounts are funded with after-tax dollars, but they grow tax-free and are distributed tax-free if specific rules are followed. Like tax-deferred accounts, these accounts have annual funding and income limits. However, these accounts have no annually required distributions, can be used as a hedge against potentially higher tax rates in the future, and can provide funds without pushing income into a higher tax bracket.
A well-balanced tax diversification strategy provides options throughout retirement and can help avoid tax spikes, higher Medicare premiums, and greater Social Security taxation. We recommend annual conversations about not only how much to save but also how to save. We collaborate with many clients on this Power of Three strategy. If you want to have a conversation about your account types and funding options, please reach out to our Financial Planning Team to get the conversation started.
This Commentary is provided by Spraker West Wealth Management, a registered investment advisor, and is for informational purposes only. It should not be construed as investment advice and is not intended as a solicitation of any specific product or service. Investments and/or investment strategies include risk including the possible loss of principal. There is no assurance that any investment strategy will achieve its objectives. Information provided is not intended as tax or legal advice and should not be relied upon as such. You are encouraged to seek tax or legal advice from a qualified professional.