RETIREMENT AND TAXES: SHOULD YOU PAY NOW OR LATER?
When saving for retirement, you have a number of options for how you’ll pay taxes: now, later or both. Just as you diversify your investments, diversifying how you save for retirement from a tax perspective is also important.
Here’s why: When you save in both taxable and non-taxable accounts, you set yourself up to have more money to spend when you’re actually in retirement. And you can better manage how you withdraw your money annually to avoid jumping into higher tax brackets.
What Are My Savings Options?
- Pay no tax now, but pay in retirement. This includes savings options like employer-sponsored plans, such as 401(k)s and 403(b)s; simplified employee pensions (SEPs); and traditional individual retirement accounts (IRAs).
These “qualified” accounts allow you to save pretax money now, which will grow tax deferred. However, you will pay tax on the money you take from your account (known as a distribution). In fact, when you retire (or turn 70½, depending on the type of account), you’ll be forced to take annual distributions known as Required Minimum Distributions (RMDs).
There are limits to how much you can contribute to each of these types of accounts in a given year. In addition, unless an exception applies, you’ll pay a penalty if you take money out of these accounts prior to turning 59½.
- Pay taxes now, not later. These types of accounts are frequently referred to as Roth accounts. Roth 401(k)s or Roth IRAs allow you to save with after-tax dollars now. You’re not taxed on the growth of your money; and when you take it in retirement, you won’t pay tax either.
There are also limits to how much you can contribute to these accounts yearly, and if you make too much money, you can’t contribute to some. You also may pay a penalty if you take money out of these accounts prior to 59½.
- Pay taxes now, as your money grows and later. Non-qualified investments—basically anything that’s not in a tax-qualified account like a 401(k)—are another option. You invest money that has already been taxed in non-qualified investments. Depending on the investment, you may be taxed on earnings or distributions along the way. And then when you sell those investments, you will pay tax on any increase in value. For instance, let’s say you invest $1,000 in a mutual fund today and then sell it 10 years from now for $1,700. The $700 you made will be treated as capital gain income the year you sell it, and the capital gains tax bracket is based on the ordinary income tax bracket you are currently in.
There is no limit on the amount of non-qualified investments you make in a year, and you can get your money anytime without paying a penalty.
Other Ways to Supplement Retirement Income
The primary purpose of life insurance is for the death benefit; however, because whole life insurance grows tax free and is guaranteed never to go down, the cash value that has grown in a life insurance policy can also be a great option to help supplement retirement income. This can give you added flexibility in years when the market is down or if you need to reduce your taxable income in a given year.
So What Option Is Best for You?
The answer to the question is different for everyone’s unique situation, but it’s a good idea to include a mix of different accounts to give yourself flexibility and greater spending power in the future. After all, you may not be in a lower tax bracket when you retire, and tax brackets are currently at historical lows. So while pretax retirement accounts can be a great start, they shouldn’t be your only savings.
Call us to have your specific situation analyzed and find the best solution.