Defer or Diversify: How should I save for retirement?
Each spring, the tax documents emerge from their hibernation as people prepare the information they need to meet their civic duty. Oftentimes, your accountant (CPA) or Financial advisor might take this opportunity to talk to you about deferring some of your income for tax purposes, but what does that mean, and is this right for you?
There are three ways your money can be treated for tax purposes. First, we need to define each of those options in order to determine what makes the most sense for you.
When you contribute to a pre-tax retirement plan (like a 401k, 403(b), or an IRA) you are getting the tax benefit at the time of contribution, meaning that you don’t pay taxes on those contributions this year. We assume that the money you contributed then grows, and as it’s growing you continue to defer the taxes on this money. Then, in retirement when you start taking your money out of this account, that is when you pay the taxes. Under current tax-law as long as you are at least 59.5 years old, your tax obligation is whatever ordinary income tax bracket you find yourself in. Prior to age 59.5 distributions are considered “premature” and the IRS will hit you with an additional 10% tax penalty. For high-income earners, deferring taxes on your income can be very valuable, assuming that you will be in a lower tax bracket once you retire.
Contributions to a taxable account are done after tax meaning the money you put in has already been taxed, and you receive a 1099 each year that a taxable event occurs (like a dividend is applied, or gains are realized). Distributions themselves are not taxable and the IRS does not put restrictions on how and when you can contribute to or distribute from these accounts. However, taking a distribution could result in a realized gain or a realized loss. Let’s talk about gains and losses. If you sell a security for more than your original investment, then you have a gain, and if you sell it for less than your original investment, you have a loss. There are two treatments for each: short-term, and long-term. If you hold a security for more than one year before you sell it, then you will realize either a long-term gain or long-term loss; less than a year and it’s short-term gains or losses. Short-term gains are taxable at your ordinary income rate, and long-term gains are taxed at a lower “long-term cap gains” rate which can be as low as 0%, and losses are used to offset gains. Confusing, right? The point is that even though you don’t get some incredible IRS-sanctioned tax benefit, this type of account can be very flexible for tax purposes and those losses that we talked about can be a very useful tool for reducing your tax liability. Another benefit over Tax Deferred or Tax-Free savings is that because you’re not getting a tax benefit, there are also no restrictions on how much, or when, you can make deposits or withdrawals.
Tax-free savings are typically Roth IRAs, Roth 401(k)’s, triple exempt municipal bonds, or cash value (aka “permanent”) 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 distributions 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. When you are young and in a relatively low tax bracket, the long-term tax-free growth of a Roth IRA or Roth 401k can be incredibly beneficial. If you have young children, then cash value life insurance is very affordable and a very useful tool. Permanent life insurance also becomes a good strategy if you are a high income earner or if you have a large asset base and are in good health.
Ultimately, the answer to “defer or diversify?” depends on your situation. Diversifying the tax treatment of your savings gives you flexibility and control of your money and your taxes. While high-income earners may want to prioritize tax-deferral, younger individuals may prioritize tax-free savings, and those who are legacy-minded would want to look at taxable savings or life insurance. It is best to meet with your accountant and your financial advisor to determine what is the best way for you to save given your age and particular circumstance.
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Written by Justin Meyer