The internet is overflowing with confident recommendations about the "optimal" way for you to allocate your savings. The truth of the matter is that there is no standard "one size fits all" order of operations with which to fund your retirement savings. While tax-efficient investing is certainly influential, it is not the end all be all of personal finance.
To make the best decisions for your unique situation, begin by educating yourself on the differences between taxable, tax-free, and tax-deferred investment accounts. In this blog post, we’ll explore the advantages and disadvantages of each account type and review some real-life scenarios to help you make informed decisions about your saving strategy.
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Taxable investment accounts, such as brokerage accounts, offer the benefit of flexibility when managing your investments. You can contribute as much as you want and access your funds without restrictions or penalties. However, unlike retirement accounts, taxable accounts do not provide immediate tax benefits. Any gains realized from investments like stocks, mutual funds, and exchange-traded funds are subject to capital gains taxes.
Despite the tax implications, taxable brokerage accounts can be an excellent addition to your investment portfolio. They provide a way to diversify your investments and can serve as an emergency reserve or a source of funds for short-term goals. Additionally, you can take advantage of certain tax-efficient investments, such as index funds and municipal bond funds, to minimize the impact of taxes on your overall returns.
Tax-free retirement accounts, like Roth IRAs (Individual Retirement Account) and Roth 401(k)s, offer valuable tax benefits for long-term retirement savings. These accounts grow tax-free and qualified withdrawals in retirement are also tax-free. However, there are income limits and filing status requirements that determine your eligibility to contribute to these accounts.
Let’s take a closer look at Roth IRAs and Roth 401(k)s.
A Roth IRA is a popular tax-free retirement account that allows you to contribute after-tax dollars. This means that while you won’t receive an upfront tax break, the account grows tax-free, and you can make tax-free withdrawals in retirement.
However, there are income limits based on your filing status and modified adjusted gross income (MAGI) that determine your eligibility to contribute to a Roth IRA. For example, in 2024, a single filer with a MAGI below $146,000 can make the full contribution to a Roth IRA, while those with a MAGI above $161,000 are not eligible. For married couples filing jointly, the income limits range from $230,000 to $240,000.
The contribution limits for a Roth IRA are $7,000 per year for those under 50 and $8,000 per year for those age 50 and over.
A Roth 401(k) is another tax-free retirement account option, offered by employers. Similar to a Roth IRA, the Roth 401(k) allows for tax-free growth and withdrawals in retirement. The main advantage of a Roth 401(k) over a Roth IRA is the higher contribution limits. In 2024, the maximum contribution limit is $23,000 for those under 50 and $30,500 for those age 50 and over.
One thing to note is that the Roth 401(k) does not have income limits like the Roth IRA. This means that regardless of your income, you can contribute to a Roth 401(k) if your employer offers one. Consult with a fee only fiduciary financial advisor to determine if a ROTH IRA or Roth 401(k) are the right choices for you.
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Tax-deferred retirement accounts, such as traditional IRAs and 401(k)s, offer tax deductions on contributions and tax-deferred growth. This means that you can reduce your taxable income in the year you make contributions, and your investments grow without being taxed until you withdraw the funds in retirement. At that point, withdrawals are taxed as ordinary income.
While tax-deferred accounts provide immediate tax benefits, they may not be the best choice for everyone. If you anticipate being in a higher tax bracket in retirement, a tax-free account like a Roth IRA or Roth 401(k) may be a better option. It’s essential to consider your future tax situation as well as the potential benefits and drawbacks of each account type when planning your retirement saving strategy.
Each investment account type has its advantages and disadvantages. Taxable accounts offer flexibility and accessibility, tax-free accounts provide valuable long-term tax benefits, and tax-deferred accounts grant immediate tax deductions on contributions.
By understanding the differences between these account types, you can make informed decisions about your investment strategy and maximize your retirement savings.
Taxable brokerage accounts provide several advantages, such as the ability to access funds without penalty and capital gains tax rates. Investments that provide dividends are also taxed at the more favorable qualified dividend tax rate, which is often lower than ordinary income tax rates. Taxable accounts have no contribution limits, allowing you to invest as much as you want.
Investments in taxable brokerage accounts will receive a step up in basis when passed to heirs after death, reducing or possibly eliminating future tax obligations that your children or beneficiaries might face.
Tax-free investment accounts, such as Roth IRAs and Roth 401(k)s, offer tax-free growth and withdrawals in retirement. These tax advantaged retirement accounts can help reduce your overall tax liability and provide greater flexibility when retirement planning.
These accounts may be suitable for individuals who anticipate being in a higher tax bracket in the future or who wish to avoid required minimum distributions. Because the investments are made with AFTER TAX money, heirs who inherit funds in ROTH accounts will have no tax obligation when taking distributions from those inherited ROTH accounts. This can be a significant advantage when planning for legacy.
ROTH accounts also have interesting potential interactions with social security and other forms of taxable income. Because distributions from ROTH accounts do not show up as income on your tax return, ROTH funds can help you stay in a lower tax bracket in retirement, resulting in less tax paid on other sources of income in retirement.
Consult with a fee only fiduciary financial advisor who specializes in retirement income planning to learn more about when ROTH contributions and conversions may be appropriate for you.
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Tax-deferred investment accounts, like traditional IRAs and 401(k)s, offer tax deductions on contributions and tax-deferred growth. This allows you to reduce your taxable income in the year you make contributions and defer taxes on investment growth until retirement. High income earners with significant surplus dollars and the ability to fund multiple investment strategies will find these account types very attractive.
Tax-deferred accounts, a type of tax advantaged accounts, can be an attractive option for investors seeking immediate tax benefits and expecting to be in a lower tax bracket in retirement.
Frequently we are called to make difficult choices about where to allocate our finite savings dollars. Short term purchase goals like a new car, a home, a wedding, honeymoon, or support for children can combat with our desire to save for retirement. Only funding retirement accounts limit access to your funds while also punishing you with an early withdrawal penalty if you need access to those funds prior to age 59 1/2.
Funding taxable brokerage accounts with some portion of your savable dollars can ensure you have access to some funds penalty free for short and medium term goals.
Creating a savings flow chart can be a useful tool to document what portion of your surplus dollars goes to which element of your savings and investing strategy.
I alluded to this above, but not all investment accounts are created equal when it comes to planning for heirs. If you are fortunate enough to be in a position where your heirs may inherit some investment accounts, know this: Tax deferred accounts are the worst account type for heirs to inherit.
Both ROTH accounts and taxable brokerage accounts offer better tax benefits to heirs. Because ROTH accounts have income and contribution limits, it can be strategically advantageous to fund taxable accounts in lieu of tax deferred accounts in specific instances.
Consult with a fee only fiduciary financial advisor to learn whether this is an appropriate strategy for you.
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Oftentimes simple is better. Income limits, contribution limits, early withdrawal penalties, forecasting future tax rates, giving up access to your savings for many years...
Sometimes complexity simply discourages us from saving AT ALL.
If that is the case for you, take a step towards better - and that can mean putting your savings into a taxable account in tax-efficient investments, such as index funds and exchange traded funds.
Later, when you have the bandwidth and or the resources you can consult with a fee only fiduciary financial advisor to identify the optimal savings matrix that includes funding tax free and tax deferred accounts.
If you’re looking to maximize your tax-free retirement savings, there are several strategies you can employ, such as utilizing backdoor Roth conversions and taxable brokerage accounts. These methods can help you make the most of your retirement savings, even when income limits prevent you from making direct Roth IRA contributions.
A backdoor Roth conversion is a strategy for high-income earners who are unable to contribute directly to a Roth IRA due to income limits. This method involves contributing after-tax dollars to a traditional IRA and then converting those funds to a Roth IRA. By doing so, you can indirectly fund a Roth IRA and enjoy the tax benefits associated with tax-free retirement accounts.
It’s essential to be aware of any potential tax implications when utilizing a backdoor Roth conversion, such as the pro-rata rule, which may cause a portion of the conversion to be taxable. Additionally, tracking the basis of the contributions and conversions can be complicated, so it’s crucial to consult with a fee only fiduciary financial advisor when executing this strategy.
Investing in taxable accounts after maxing out your retirement contributions can help supplement your tax-free retirement savings. Although these accounts do not offer the same tax benefits as tax-free retirement accounts, they can still provide a valuable source of additional savings for your retirement.
With a strategic retirement income strategy, distributions from taxable accounts below a certain amount can limit your capital gains tax to the 0% bracket. Properly executing such a strategy requires a great deal of foresight and advance planning. It will require strategically locating saved dollars between taxable and ROTH accounts to allow for sufficient retirement income while staying below capital gains tax thresholds.
Consult with a fee only fiduciary financial advisor for guidance executing such a strategy.
Click here to schedule a free no obligation consultation with our Fee Only Fiduciary Financial Planning team.
To maximize the benefits of tax-free retirement accounts, it’s important to be aware of and avoid common pitfalls, such as excess contributions and early withdrawals. These mistakes can lead to penalties and income taxes, negating the tax advantages of these accounts.
By understanding and adhering to contribution limits and withdrawal rules, you can optimize your tax-free retirement savings.
Contributing more than the annual limit to a Roth IRA can result in penalties. The IRS imposes a 6% penalty tax on the excess amount for each year it remains in the account. To avoid this penalty, it’s crucial to understand and adhere to the contribution limits for your specific retirement account.
If you do make excess contributions, the best way to avoid the penalty is to remove or reduce the excess contribution before the tax filing deadline. This will help ensure that you stay within the IRS guidelines and avoid any penalties or complications.
Withdrawing funds from a Roth IRA or Roth 401(k) before age 5912 can result in taxes and penalties. Early withdrawals are typically subject to a 10% penalty and taxed as ordinary income. However, there are some exceptions to this rule, such as using IRA funds to cover medical insurance premiums after a job loss.
Understanding the differences between taxable, tax-free, and tax-deferred investment accounts is essential in order to make informed decisions about your investment strategy and maximizing your retirement savings. What location (account type) to place savings in, how those accounts are taxed, and ultimately how to invest within those accounts are things you can control, and thus use to produce better retirement outcomes.
As usual, we recommend consulting with a fee only fiduciary financial advisor to construct a robust financial plan that will educate and guide you in these matters.
Click here to schedule a free no obligation consultation with our Fee Only Fiduciary Financial Planning team.
Taxable accounts are taxed using capital gains rates.
ROTH accounts offer tax-free growth AND tax free withdrawals after age 59 1/2.
Tax deferred accounts reduce your current year taxes in exchange for paying taxes at ordinary income tax rates on the principal AND growth upon taking withdrawals after age 59 1/2.
For 2023, single filers can have an income ranging from $146,000 to $161,000 for a Roth IRA, while married couples filing jointly can have an income between $230,000 and $240,000.
These income limits are subject to change each year.
If you contribute more than the legal limit to your Roth IRA, the IRS will apply a 6% penalty tax on the excess amount for each year it remains in the account.
It’s important to stay aware of the contribution limits in order to avoid this penalty.
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