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Defer or Diversify

It’s that time of year again, when most of us are meeting with accountants or CPAs and tallying up our income from the previous year.  It’s not uncommon for your financial advisor or tax preparer to talk to you about deferring some of your income through contributions to a pre-tax retirement account like an IRA, 401(k), 403(b), etc.  Though tax deferral does have its benefits, is it always the right decision?

When you contribute to a pre-tax retirement plan, you get the advantage of writing that contribution off on your income taxes.  However, when you begin to do withdrawals from these types of accounts, the entire amount of those withdrawals is taxable at your ordinary income rate.  You could also incur additional tax penalties if you take withdrawals prematurely (the definition of “premature distribution” varies depending the type of account).  While most people plan to be in a lower tax bracket during retirement, if you put all your eggs in a tax deferred basket, it leaves you with less flexibility or control over your taxes in retirement.

There are two other ways your savings can be treated from a tax standpoint.  Of those is in a non-qualified or “taxable” account.  With taxable accounts you don’t get to write off your contributions and you receive a 1099 each year a taxable event occurs, like a dividend is applied, or gains are realized.  Distributions from taxable accounts are typically at a long-term capital gains rate which is lower than your ordinary income rate.  You also have the flexibility of harvesting losses from these types of accounts, which can help mitigate or minimize what you pay in taxes.

The third taxation options is tax free growth. Tax-free savings are typically Roth IRAs, Roth 401(k)’s, triple exempt municipal bonds, or cash value life insurance.  Much like a taxable account, you don’t have the benefit of writing off contributions on your taxes, but tax-free investment vehicles grow, well, tax-free!  This means that when you begin to take withdrawals from this type of investment that it doesn’t generate a taxable event.  There are often criteria that you must meet in order to take advantage of the tax-free growth.  For example; a Roth IRA will produce tax-free income if you’re over 59 ½ years old, and the account has been established for at least 5 years.  Cash value life insurance has contribution limits and needs to provide a death benefit under the policy to remain tax-free.

Ultimately the answer to “defer or diversify?” is: there is no cookie-cutter answer that works best for everyone.  While diversifying the taxation of your savings will allow for flexibility and control over your taxes in retirement, those who are in a high tax bracket may want to max out their pre-tax savings first. It is best to meet with your accountant and your financial advisor to determine what is the best way for you to save.

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This commentary on this website reflects the personal opinions, viewpoints and analyses of the Financial Strategies Group, Inc employees providing such comments, and should not be regarded as a description of advisory services provided by Financial Strategies Group, Inc or performance returns of any Financial Strategies Group, Inc Investments client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. Financial Strategies Group, Inc manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

This article is written by Kyle Cooper.

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