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Retirement is an important financial goal, and there are many different ways to get there. A common path is via a 401(k), a pre-tax retirement plan offered by many employers. As a financial planner, I'm a big fan of these plans — they encourage automatic contributions and sometimes come with employer matching. But, I also believe you shouldn't be putting your whole nest egg in one basket.
Maybe you've heard about the power of diversification when it comes to choosing your investments — investing in too much of one thing can open you up to more risk and make you susceptible to market swings. But did you know you should also diversify where you invest? When it comes to saving for retirement, I believe tax diversification is just as important as portfolio diversification.
Taxes affect how much money you get to keep in retirement, and tax diversification is a strategy to help your money last. Your retirement accounts contain either tax-deferred, taxable, or tax-free funds. Creating a strategy that accounts for the various tax treatments of your accounts can help you save money and give you more flexibility in how you access your savings.
Retirement plans are made of either pre-tax or post-tax contributions (or a mix of both). Pre-tax contributions, typically found in your standard 401(k), reduce your income taxes during your pre-retirement years, while after-tax contributions, typically found in Roth IRA and Roth 401(k) accounts, help reduce your tax burden in retirement. You can also save for retirement in traditional investing accounts, which are often after-tax contributions.
Pre-tax contributions allow you to delay paying taxes on contributions and earnings. For example, if you contribute to your company's 401(k), any money you add to it and any growth on your investments won't be taxed as long as the money stays in your account. When you retire, you'll pay taxes, but there's a chance you'll be taxed at a lower rate because your taxable income and tax bracket is lower than in your working years.
Post-tax contributions provide tax-free income in your golden years, and can reduce your overall tax burden in retirement.
The benefits of tax diversification in retirement
Investing in both pre- and post-tax retirement accounts gives you the best of both worlds. Having a balance between these two different tax streams offers more flexibility and sustainability for your savings and makes your accounts more resilient against future tax law changes.
Having tax diversification helps provide some order in how you should take withdrawals in retirement, helping you structure your withdrawals to maximize your after-tax income. Typically, once you reach retirement age, you'll begin taking required minimum distributions from your accounts. To get the biggest benefit, you'll take distributions from tax-deferred accounts, and then distributions from tax-free accounts. Of course, it's important to consult your personal financial advisor or tax professional to get a specific tax-minimizing plan.
So, where should you be investing? I recommend a combination of a few different accounts.
My rule of thumb is to invest first in your 401(k), if your company offers one. Make sure you're at least contributing up to your employer's annual maximum match, otherwise you're just leaving money on the table. If you have extra funds available, consider investing next in an after-tax account like a Roth IRA or Roth 401(k). Keep in mind there is an income eligibility requirement for Roth IRAs. Lastly, consider a taxable brokerage account for the rest of your nest egg savings.
What makes this strategy a winner? All withdrawals from your pre-tax retirement accounts are taxed as ordinary income, while all withdrawals from your taxable accounts (from the sale of stocks or mutual funds) may be taxed at capital gains rates, depending on your income and how long you held the investment. Any withdrawals from your post-tax retirement accounts are completely tax-free. In other words — like the benefits of portfolio diversification, tax diversification reduces your overall risk from tax law changes or other policy changes.
Overall, the goal of retirement is to enjoy yourself after years of work. The last thing you want is to be dealing with taxes or finding yourself with less than you thought you'd have after Uncle Sam takes his cut. Tax diversification will help reduce this risk (and worry) for your future.
This article was originally published in April 2022.
Hanna Horvath
Hanna Horvath is a CERTIFIED FINANCIAL PLANNER™ and personal finance reporter based in New York City. Her work has appeared in Policygenius, NBC News, MSN, Inc Magazine and more.
But, I also believe you shouldn't be putting your whole nest egg in one basket. Maybe you've heard about the power of diversification when it comes to choosing your investments — investing in too much of one thing can open you up to more risk and make you susceptible to market swings.
When thinking about retirement, saving more is usually a good idea. For people who earn a lot of money, just putting all their savings into a 401(k) might not be enough when they retire. Even if they max out their 401(k) every year, they could still end up with less money to live on after they stop working.
With a 401(k), you will have to pay income tax on your contributions and the investment gains when you withdraw funds from the account. “Without knowing for certain how your 401(k) will perform or what the taxes will be in the future, your 401(k) can be a ticking tax time bomb,” Rubio said.
Combining accounts can help you maintain a good balance
When you have multiple accounts, there's a tendency to look at each one individually. That can leave you with a skewed picture of your overall mix of stocks, bonds, and cash (a money market fund, for example).
Because 401(k) plans tend to limit your investment choices, you may end up having to put your money into funds that come with costly fees, known as expense ratios. On top of that, there can be administrative fees associated with your 401(k) that are passed on to you. With an IRA, your fees might be lower.
Prioritize savings if you don't have an emergency fund. Consider investing what you can if you're eligible for a 401(k) match. Choose saving over investing if you'll need the cash in the near future.
However, the general rule of thumb, according to Fidelity Investments, is that you should aim to save at least the equivalent of your salary by age 30, three times your salary by age 40, six times by age 50, eight times by 60 and 10 times by 67.
The value of 401(k) plans is based on the concept of dollar-cost averaging, but that's not always a reliable theory. Many 401(k) plans are expensive because of high administrative and record-keeping costs. Nonetheless, 401(k) plans are ultimately worth it for most people, depending on your retirement goals.
Good alternatives include traditional and Roth IRAs and health savings accounts (HSAs). A non-retirement investment account can offer higher earnings but your risk may be higher. Investment accounts don't typically come with the same tax advantages as retirement accounts.
In short, 401(k) funds lack liquidity. This is not your emergency fund or the account you plan to use if you are making a major purchase. If you access the money, it is a very expensive withdrawal. If you withdraw funds prior to age 59-1/2, you potentially will incur a 10% penalty on the amount of the withdrawal.
Fidelity's guideline: Aim to save at least 1x your salary by 30, 3x by 40, 6x by 50, 8x by 60, and 10x by 67. Factors that will impact your personal savings goal include the age you plan to retire and the lifestyle you hope to have in retirement. If you're behind, don't fret.
To help people determine how much to save for retirement, investment experts provide various rules of thumb to give you some benchmarks. For example, you may be advised to contribute 10% to 15% of your gross income every year, or aim to have 25 times your projected annual spending when you retire.
As a general rule, if you withdraw funds before age 59 ½, you'll trigger an IRS tax penalty of 10%. The good news is that there's a way to take your distributions a few years early without incurring this penalty. This is known as the rule of 55.
The Bottom Line. In a 401(k) vs. Roth IRA matchup, a Roth IRA can be a better choice than a 401(k) retirement plan, as it typically offers more investment options and greater tax benefits. It may be especially useful if you think you'll be in a higher tax bracket later on.
“If an investor decides to pause or stop contributions, they are not only slowing their own compounding progress, but they are leaving the match — which can be thought of as free money — on the table. The best plan of action for long-term investors is to stay the course with their retirement savings efforts.”
Key takeaways. Fidelity's guideline: Aim to save at least 1x your salary by 30, 3x by 40, 6x by 50, 8x by 60, and 10x by 67. Factors that will impact your personal savings goal include the age you plan to retire and the lifestyle you hope to have in retirement.
That's typically an option when you stop working, but be aware that moving money to your checking or savings account may be considered a taxable distribution. As a result, you could owe income taxes, additional penalty taxes, and other complications could arise.
A general rule of thumb says it's safe to stop saving and start spending once you are debt-free, and your retirement income from Social Security, pension, retirement accounts, etc. can cover your expenses and inflation. Of course, this approach only works if you don't go overboard with your spending.
Introduction: My name is Dean Jakubowski Ret, I am a enthusiastic, friendly, homely, handsome, zealous, brainy, elegant person who loves writing and wants to share my knowledge and understanding with you.
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