The importance of saving for retirement has probably been drilled into you since you first started working. But how and where you save is equally important. In fact, what often gets overlooked is that the location of your investments — in tax-free, tax-deferred, or taxable accounts is also super important. That’s because how you organize your investments determines your overall investment returns, affects how much you will pay in taxes, and ultimately, the funds you will have available to support yourself in and through retirement.
A good retirement savings strategy should take your retirement goals, post-retirement spending needs, estimated time in retirement, investment risk tolerance, and tax planning into consideration. Here’s what you need to know to help you preserve more money in retirement.
1. Keep Asset Location Front And Center
As they say in real estate, location, location, location! By this, I’m referring to where you place your investment assets. asset location is different from asset allocation† The latter refers to the mix of different types of investments (including stocks, bonds, real estate, and alternatives such as private funds or precious metals) you choose for your portfolio. Asset location, on the other hand, means the type of investment vehicles — tax-deferred, taxable, or tax-free accounts you use to save for retirement.
Having a well-diversified portfolio — one with a mix of different types of investments — is important because studies show this matters far more than almost anything else you can do when it comes to hitting your investment goals. Having retirement accounts with differing tax treatments is important because it gives you the flexibility to time your withdrawals in a way that reduces the taxes you pay. And that can mean your retirement funds last longer.
Pro Tip: Taxes shouldn’t drive your investment decisions. But by the same token, you don’t want to make decisions in a vacuum, only to be faced with a big and unnecessary tax hit down the road that you could have avoided with a little advance planning.
2. Open A Roth IRA Account And Contribute To It Each Year
Roth IRAs, named for former Senator William Roth, are tax-free retirement savings accounts. While these accounts don’t save you taxes upfront, they allow your investments to grow tax-free. That can really pay off down the road.
Because you make contributions to a Roth IRA with money you’ve already paid taxes on, you won’t owe taxes on funds you withdraw from them in the future, provided you are at least age 59 and a half when you start withdrawing funds and your account has been open for at least 5 years.
That can mean a real difference in how much money you ultimately end up with in retirement. Consider this: Let’s say you have a 401(k) account and a Roth IRA. Assuming you are in the 24 percent income tax bracket, you’ll pay $240 in federal income taxes on a $1,000 withdrawal from your 401(k) in retirement. With draw that same amount from your Roth, and you won’t owe any taxes.
Another great benefit of Roths is that you don’t have to take required minimum distributions (RMDs) from them each year once you reach a certain age. Those withdrawals, which you have to take from 401(k), 403(b), 457 (b), and individual retirement accounts (IRAs) including SEPs and SIMPLEs beginning the year you turn 70 and a half, are taxable. And RMDs are just that — required. If you don’t take your distributions on schedule, you could owe a tax penalty on top of any income taxes due on your withdrawals.
Pro Tip: If Roth accounts sound too good to be true, they almost are. Not everyone can contribute directly to one because they are subject to income limits. If your income is too high to contribute to a Roth, you can still accomplish the same goals by setting up a backdoor Roth, officially called a Roth conversion. To do this, you set up a regular IRA, then immediately rollover funds from a pretax or tax-advantaged account like a 401(k). You’ll have to pay taxes on any funds you convert to a Roth, but the upside is once you’re in retirement you can withdraw your funds and any earnings on them tax-free.
3. Keep Income Producing Assets In Tax-Deferred Accounts
Tax-deferred accounts such as 401(k)s, IRAs, and health savings accounts (HSAs) are good places to stash assets you have in actively managed funds or investments that tend to generate lots of income (bonds), pay dividends (utility company stocks), and/or have the potential to produce large capital gains (growth stocks).
You can save taxes by keeping them in accounts where you can delay paying taxes for as long as possible.
4. Keep Tax-Efficient Investments In Taxable Accounts
Passive investments — think index mutual funds and ETFs — by definition should see minimal trading. They work well in your taxable accounts since they won’t generate regular capital gains from selling that you’ll end up owing taxes on.
5. Be Strategic With Your Withdrawals In Retirement
Timing is everything. Unfortunately though, if you’re already retired, you can’t travel back in time and change the way you set up your accounts. But you can be savvy with what you do going forward.
If your main goal is to minimize the taxes you pay in retirement, then you’ll likely want to tap funds in your taxable accounts first. That’s because you may find yourself in a higher tax bracket once you reach the age when you have to start taking RMDs. That’s especially true if you’re still earning income, say from part-time work, while you’re in retirement.
In some cases though, withdrawing the same yearly amount but spreading your withdrawals proportionately across all your accounts could save you more in taxes. Speak with your tax advisor and your financial planner if you have one, to discuss what strategies make sense for your specific circumstances.
Pro Tip: If your income from RMDs is likely to push you into a higher tax bracket in a given year, you could lower or minimize your tax bill by directing some of your withdrawal to a qualifying charity.
Think holistically when it comes to your retirement planning. You’re probably already thinking through whether and how to downsize, when and if to relocate, and how you want to spend your time and money in retirement. Adding some proactive tax planning into the mix is an essential arrow in your quiver that can help you make the most of your retirement. While death and taxes are the only certainties in life, savvy planning now can help you minimize what and when you pay the taxman, so you can enjoy more of your hard-earned savings.
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