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For most of us, having a retirement with a handsome pension and Social Security benefits to cover expenses is no longer an option. We are fully responsible to save our income and invest our assets in order to build a nest egg for retirement. This is not an easy task and many difficult decisions must be made along the way.
We have all heard that diversification is an important part of this process. When people mention diversification they discuss how to invest in domestic and international equities, bonds, real estate and alternative investments. The equity allocation can be further diversified between small-, mid- and large-sized companies. These are very important decisions as you are planning for retirement. Another type of diversification to consider is how your dollars are allocated between asset buckets. These buckets include taxable, tax-deferred and tax-free assets. Each one has advantages and disadvantages.
Our earnings are taxed when they are earned, then those dollars are taxed again as they generate income. The taxable bucket is less tax efficient as it is subject to two taxable events: earnings and growth. But the benefit is in the liquidity and lack of restrictions. If you need the funds, they are available. When you want to add money to the taxable bucket, you are not restricted in the amount or timing of those contributions. This flexibility is important as you build assets and withdraw them in the future.
Assets in your 401(k) or IRA would be the tax-deferred bucket. You receive a deduction from income when you make contributions. The contributions grow tax deferred, but the distributions are taxed at the applicable ordinary income rates. This is the most common bucket used to build assets for retirement. The deduction received when making contributions reduces your taxable income and taxes.
Having the assets grow tax deferred is an advantage. With the taxable bucket, you need dollars to pay the taxes on the interest, dividends and capital gains you earn. With the tax-deferred bucket, you keep those dollars and they continue to grow. Albert Einstein is quoted as saying, “The most powerful force in the universe is the power of compound interest.”
If you require a large cash flow from the tax-deferred bucket for expenses, you can be pushed into higher tax rates. That dream retirement vacation becomes more expensive when you have to use dollars from the tax-deferred bucket.
The Roth IRA and Roth 401(k) would be the tax-free bucket. Taxes are due when the money is earned. Contributions are made with after-tax dollars, grow tax free and when qualified distributions come out of the account, they are not subject to tax. The Roth IRA has been around for over a decade but it does have income restrictions that prevent some individuals from contributing. The Roth 401(k) is a more recent option but not every retirement plan has accepted this plan.
The Roth is the best of all three options. You receive the same growth benefit of the tax-deferred bucket. When you pay $15,000 for your dream vacation, you don’t have to worry about taxes or your tax rates. You can take your contributions out of the Roth any time and they will not be subject to taxes or penalties. This does provide some liquidity options. Withdrawals need to be qualified distributions or they will be taxed and penalized. You pay taxes today but it is easier to pay taxes while you have income versus just having a nest egg of assets.
We are typically taxed in at least one of three events: when we earn money from our job or a business we own; when assets grow by interest, dividends and capital gains; and when we take money out of an account like a distribution from an IRA. Being taxed less is typically the most desirable, but sometimes paying more now may be a good decision.
Mix it Up
We know the tax rates we pay today but we don’t know what rates we will pay in the future. Having some assets in each bucket will give you a better opportunity to be strategic with your taxes in retirement. For instance, a married couple who is retired and needs $100,000 for expenses can influence their tax rate if they have diversified their asset bucket. They could take the first $36,250 from the tax-deferred bucket. This strategy will use up the 10 percent and 15 percent tax brackets and will not push into the higher 25 percent bracket. The balance of $63,750 could come from the taxable and tax-free bucket.
Building assets for your retirement involves making many good decisions as you go. Having a financial advisor can help you understand and evaluate these decisions. As you are building your nest egg, consider how you have diversified among these asset buckets as it may give you a better opportunity to be strategic with your assets during retirement.
— Devin Pope is a certified financial planner with Albion Financial Group.