It’s that time of year again when most of us are meeting with accountants and CPAs to tally 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 pre-tax retirement accounts like an IRA, 401(k), 403(b), etc. Though tax deferral does have its benefits, it may not always be the right decision.
When you contribute to a tax-deferred retirement plan, you get the advantage of writing that contribution off on your income taxes. However, when you begin to withdraw from these types of accounts, the entire amount of those withdrawals are taxable at your ordinary-income rate. In some cases, you can also incur an additional tax penalty for early distributions. While most people plan to be in a lower tax bracket during retirement but with today’s historically low tax rates that may not be the case. The benefit of a tax write off isn’t what it used to be, and saving exclusively in tax-deferred accounts leaves you with less flexibility or control over your taxes in retirement.
There are two other ways your investments can be treated from a tax standpoint. One of those is a “taxable” account. Contributions to taxable accounts are made with after-tax “paycheck money” and there is no tax write off, and you still receive a 1099 each year a taxable event occurs (like a dividend is applied, or gains are realized). However, distributions from taxable accounts are typically taxed 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 option 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 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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Written by Justin Meyer