Saving in accounts with different tax treatments can help you minimize taxes in retirement.
If you do all of your saving for retirement in traditional 401(k)s and individual retirement accounts, you could face hefty required withdrawals in retirement that bump you into a higher tax bracket. Conversely, saving for retirement in accounts with different types of tax treatments including traditional retirement accounts, Roth accounts and taxable investment or savings accounts adds tax diversification and flexibility to your portfolio. Here’s how to control your tax bills in retirement:
Traditional 401(k)s and IRAs. Contributions to traditional 401(k)s and IRAs are excluded from your current income, and you don’t have to pay tax on that money until you take it out, presumably in retirement. However, once you turn age 70 1/2, annual withdrawals become required and the tax bill is due on each distribution.
Roth 401(k)s and Roth IRAs. Roth account contributions are made with after-tax dollars, but withdrawals in retirement from accounts that are at least five years old are tax-free. Withdrawals from Roth accounts aren’t required at any age, so you have the flexibility to take the money out when you need it without tax consequences or leave the money in the account for later in retirement or even leave it to heirs. “If their tax rate is higher now than it will be in the future, we will have them mostly contribute to a traditional account, but if a young person comes in and we are pretty sure that their tax rate is going to be the same or greater in retirement, then we are going to have them do a Roth,” says Eric Mancini, a certified financial planner for Traphagen Financial Group in Oradell, New Jersey. “As a general rule, the younger the client, the more they should be tilted to Roth 401(k)s or Roth IRAs.”
Taxable accounts. Regular savings and investment accounts typically require you to pay taxes on the gains in the account each year, and there are no tax perks for contributing. However, these accounts are also the most accessible for spending or emergencies, and there aren’t penalties for withdrawing your money before a certain age. “Don’t forget to start stockpiling a taxable account, because that gives you so much flexibility in your 60s,” says Bryan Clintsman, a certified financial planner and principal of
Clintsman Financial Planning in Southlake, Texas. “The more you get in there, the more years you are going to be able to live on that and defer access to the tax-advantaged account.”
The order of saving. The highest return you are likely to receive on an investment is a 401(k) match, so getting that should be your first priority. After that, there is room to diversify your saving. “First, you get your match from your company, and then I would say the Roth type of account is next, and then the tax deduction type accounts are after that,” says Joe Franklin, a certified financial planner and president of Franklin Wealth Management in Hixson, Tennessee. But he cautions: “If you don’t have anything outside of retirement accounts, an emergency can be a problem. You always want to have your emergency fund set aside. “
The order of spending. In retirement, you can draw from all three types of accounts in a way that minimizes your tax bill. “For most people, generally the order of withdrawals in retirement is taxable first, and then tax-deferred and then tax-free,” Clintsman says. “You want to save the Roth for last because every single dollar of earnings is tax-free.” However, there is also an exception to this order of spending. If you have a very large traditional 401(k) or IRA balance and you’re going to need to pay a high tax rate on the withdrawals, it can make sense to start taking distributions before you are required to so you can space them out over more years and perhaps pay a lower tax rate on at least some of the distributions. “If they are in a low tax bracket – 15 percent or less – we look to actively convert traditional IRAs to a Roth,” Mancini says. “In retirement, there are a lot of advantages to having amounts in taxable, Roth and traditional accounts. It brings the required minimum distribution down when they get to 70 1/2.”
Maintaining a balance in accounts with different tax treatments heading into retirement gives you options to minimize your tax bill each year. “You want to keep some balance in all three types of accounts: the taxable, the tax-deferred and the tax-free,” Clintsman says. “There might be some years taking a disproportionate amount from one of them is important."