Three Different Investment Account Types Can Help
The tax treatment of investment accounts can oftentimes be overlooked by most investors. This plays a big role when it comes time to start living off of the nest egg you have built up when you enter retirement. While we are working and saving throughout our career there are three different options for the ways we can save and invest our money. The three account types are: Pretax, Roth and Taxable accounts. Due to the fact that the tax laws are constantly changing it is important to have these three buckets as you are preparing to live off your savings. Below I will describe each of these account options and why they are important.
Bucket #1 Pretax Savings
Your pretax accounts would typically be any workplace retirement plans, these can include 401k’s, 403b’s, 457’s, Defined Benefit plans etc. These accounts are most often rolled over into a Rollover IRA and maintain that pretax status. These accounts receive contributions directly from your paycheck without getting taxes deducted. If your employer offers a company match, those contributions are also pretax.
The benefit of these types of accounts is that they lower your income taxes in the year you make the contributions. They also reduce the income tax for your employer’s who make the contributions for that year. This is beneficial for those working that may be in a high tax bracket right now. That is because the money they contribute now is not taxed and instead the money is taxed as you withdrawal the funds from your account. By holding these accounts over the long term you are allowing your money to stay invested and compound throughout your career. If you were to look at historical averages of the stock market, the longer this money is invested the higher likelihood that it will grow. The expectation is that when those individuals retire they will be in a lower tax bracket when they take the money out, therefore, creating a clear tax incentive to make contributions towards your retirement.
What are some negatives: If an investor only has pretax savings in retirement this could lead to significant taxes in retirement. That is because every dollar that is taken out of these accounts is added to income and taxed in the year they are withdrawn. If you include these withdraws with any other income in retirement this can place retirees in a high tax bracket for the entirety of their retirement. We do not know what the tax brackets will be in the future and who is to say that they will not increase. The way to reduce your risk of high taxes is to have other types of accounts to withdraw from that are taxed differently.
Bucket #2 Roth Savings
Roth savings is money that is contributed into a Roth IRA or Roth 401k and is taxed upfront. Theses contributions can then be invested in different stocks, bonds or mutual funds. The key advantage of a Roth is that as long as this account has been opened for 5 years and you are over the age 59.5 all withdrawals are tax free. The way to take full advantage of your Roth is to have this money invested over the long term to grow as much as possible. All of your investment gains can then be withdrawn from your account tax free. This gives investors a different option in retirement and the ability to access savings tax free. This can ensure that you stay in a certain tax bracket in retirement and not continue to climb into higher rates by only taking taxable withdrawals. This is also beneficial for those looking to pass on money to their beneficiaries. For a complete resource for the benefits of Roth savings check out my prior blog post here. https://incline-wealth.com/2020/04/reasons-for-roth-retirement-savings-now/
What are some negatives: The downside to Roth savings is the chance that you may be in a significantly higher tax bracket now than you will be in retirement. Therefore, you are paying the taxes early at a much higher rate then you would have to in retirement.
Bucket #3 Taxable(Non Retirement) Accounts
Taxable/non retirement accounts is money that is placed into an investment or brokerage account. There are no contribution limits on the amounts that can be contributed. These accounts are typically free to invest in a variety of different investment vehicles. Taxable accounts qualify for capital gains treatment for tax purposes. That means that the money that you contribute has already been taxed, therefore, the only additional tax you would pay would be from gains on your investments. The advantage of having these types of accounts in retirement is that the principal balance has already been taxed, therefore, if you only withdrawal that portion of the account you will not pay taxes again. Also, any capital gains that you withdrawal experience different tax treatment and are not taxed at ordinary income tax rates. This can then keep investors in a lower tax bracket by using this money to live off of in retirement.
What are some negatives: This money is the least advantageous from a tax perspective because the money is already taxed when you received it from earnings or wages. The money is then invested and any of the gains you must pay a percentage of capital gains tax on. If you were to lose some of the money you invested you would be able to offset gains and use a portion to offset ordinary income.
Why do you need all three?
Tax brackets are a constant topic of conversation for our elected officials and are changed often throughout history. It is important to have all three buckets for your retirement savings so that you can take as tax efficient withdrawals as possible. With the differing tax treatment of each of these buckets you can decide which lever to pull that will benefit you the most in retirement. This is all determined by what other income you have and what the current tax brackets are while you are in retirement. Although no one knows exactly what their income will be in the future we do know that the tax code is constantly changing. Here is a look at what the tax brackets were before the TCJA. Democratic candidate Joe Biden has proposed raises to the tax brackets and these are likely to change again if the Democrats take control of the White House and Senate.
It is important to ensure you are saving in a tax efficient manner for your retirement next egg. If you would like to schedule a call or zoom meeting to discuss how to implement a plan for your savings Click Here
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