Where to Invest Your Money?
Current and future taxes are an important consideration when it comes to choosing the type of account in which you save and invest. Anything you save for your retirement is good, but if you can pay Uncle Sam less, you will have more for yourself.
Tax-deferred accounts were established to encourage people to save for retirement. Their main attraction is the tax advantages they provide. Some accounts offer a tax deduction for the amount contributed. Also, taxes on the income and capital gains generated on investments are deferred until funds are withdrawn down the road. Prime examples include employer 401(k) accounts and traditional IRA accounts. Deductions for IRA accounts may be limited if you are participating in a company retirement plan.
Other accounts, such as Roth IRAs and Roth 401(k)s, offer tax-free growth of the investments in them, as long as you hold the account for the required time period and don’t withdraw funds until you are 59 and a half. However, you do not get a tax deduction for Roth contributions.
Money you save in taxable accounts, such as a regular investment or brokerage account, will not create a current tax deduction. And you pay income tax annually on any capital gains and income generated. The capital gains tax rate, however, may be much lower than your ordinary income tax rate.
Retirement plan contributions can generate substantial tax savings. If you contribute $20,000 to a 401(k) plan and are in the 25 percent tax bracket, you save $5,000 in federal income taxes. The $5,000 saved means you only had to come up with $15,000 of net deposits. Making the maximum allowed annual retirement plan contribution seems highly advisable. So, what is the down side?
When it comes to certain retirement accounts, you pay later for all the tax savings you get now. When you withdraw from your regular 401(k) and traditional IRA funds down the road, all of your deductible contributions, plus the earnings and growth on your investments, are taxed as ordinary income.
Let’s use an example. Joe and Sue both contributed the maximum allowed to their employer retirement plans annually during their working years. When they retired at age 65, they wanted $75,000 annually to supplement their social security income. Because the withdrawals are taxable and they were in the 25 percent tax bracket, they had to withdraw $100,000 to have $75,000 to spend after taxes. The extra $25,000 expense was something they hadn’t planned on, and was a substantial cost to access their savings.
You can avoid this problem by saving in Roth accounts and taxable accounts in addition to regular 401(k) and traditional IRA accounts. Consider balancing your investments between these types of accounts to obtain current tax deductions while minimizing future tax liabilities. When you can control the taxes, it allows more flexibility in tapping into funds for spending.
If Joe and Sue had been able to access $75,000 in a taxable investment account each year for the first five years of retirement, they could have avoided paying $125,000 in income taxes and allowed their tax-deferred retirement accounts to grow during this period. They would have some taxable income to report annually on their taxable portfolio, but it would be substantially less than having to report all the withdrawals from their IRAs as ordinary income.
As with everything in life, investing is a balancing act. Balance your savings between tax-free, tax-deferred and taxable accounts for the best long-term results and lowest overall payments to Uncle Sam.
This commentary originally appeared October 20 on TheCasperStarTribune.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2015, The BAM ALLIANCE