- A 401(k) is a great retirement savings account, but it shouldn’t be the only one you choose.
- Contribute up to your employer’s matching contribution, then put money into a Roth account and a taxable account.
- Tax diversification in retirement will protect you from tax law changes and keep your money flowing.
Retirement is an important financial goal and there are many different ways to achieve it. One common path is through 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 an employer match. But I also think you shouldn’t put all your savings in one basket.
You may have heard about the power of diversification when it comes to choosing your investments: Investing too much in one thing can expose you to more risk and make you susceptible to market swings. But did you know that you should also diversify where do 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 can keep in retirement, and tax diversification is one strategy to help your money last. Your retirement accounts contain funds that are tax-deferred, taxable, or tax-free. Creating a strategy that takes into account the various tax treatments of your accounts can help you save money and give you more flexibility in how you access your savings.
Choose pre-tax and post-tax retirement accounts
Retirement plans are made from contributions before or after taxes (or a combination of both). Pre-tax contributions, typically found in your standard 401(k), reduce your income taxes in the years leading up to retirement, while after-tax contributions, typically found in Roth IRAs and Roth 401(k), help reduce your tax burden in retirement. You can also save for retirement in traditional investment 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), the money you add and the growth of your investments will not be taxed as long as the money remains in your account. When you retire, you’ll pay taxes, but there’s a chance you’ll pay taxes at a lower rate because your taxable income and
tax bracket
is less than in his working years.
After-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 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 spread helps provide some order in the way you must make withdrawals in retirement, helping you structure your withdrawals to maximize your after-tax income. Generally, once you reach retirement age, you’ll begin taking required minimum distributions from your accounts. To get the most benefit, you’ll take distributions from tax-deferred accounts and then distributions from tax-free accounts. Of course, it is important to consult your personal financial advisor or tax professional for a specific tax relief plan.
The 3 accounts you should consider
So where should you invest? I recommend a combination of a few different accounts. My rule of thumb is to invest in your 401(k) first, if your company offers one. Make sure you’re contributing at least up to your employer’s annual maximum match, otherwise you’re just leaving money on the table. If you have additional funds available, consider investing next in an after-tax account like a Roth IRA or Roth 401(k). Please note that there is an income eligibility requirement for Roth IRAs. Lastly, consider a taxable brokerage account for the rest of your 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
based on your income and how long you held the investment. All after-tax withdrawals from your retirement accounts are completely tax-free. In other words, like the benefits of portfolio diversification, tax diversification reduces the overall risk of changes in tax law or other policy changes.
In general, the goal of retirement is to enjoy yourself after years of work. The last thing he wants is to deal with taxes or find himself with less than he thought he would have after Uncle Sam took his cut. Tax diversification will help reduce this risk (and concern) for your future.