In past articles I have advocated the concept of spreading your tax-treatment out – so that you have money allocated in three major types of accounts: deferred tax (such as IRAs and 401(k) plans), tax-free (Roth IRAs), and capital gains taxable accounts. The reason behind this is that our fine government has this tendency to change the rules, often, and by spreading your tax treatment out you can help to ensure that funky new rules don’t throw off your entire retirement investing plan.
The trick to all of this is to know how much to have in each kind of account… of course there are no hard and fast rules to determine what’s the best percentage to have in each kind of plan, but below is a discussion of some of the factors that you should consider as you balance out your tax treatment.
Early in life…
Early in your investing career it probably makes the most sense to load as much of your savings into your 401(k) or other tax-deferred savings vehicle as possible, in order to maximize the benefit from tax savings up front. The biggest reason for this (beyond the tax savings) is so that you take advantage of your employer’s matching benefit, along with deferring taxes on your income as it increases over time.
Later in your career when your income is higher, maximizing contributions to tax-deferred accounts will have a greater benefit to you from a tax savings standpoint – and this is assuming that you expect for the taxes you’ll pay later (during retirement) will be lower due to your diversification of tax treatment.
Also early in your investing career, as your income supports it you should begin making contributions to your Roth IRA as soon as possible. This is partly due to the restrictions on income around investing in Roth IRAs – but mostly because you are paying tax at lower rates (in your lower-earning days) than you might later on in your career when your income increases.
And then on top of it all, when your income has grown to a point that you can maximize the other options (401(k) and Roth), you should begin investing in an account that is treated by capital gains tax (primarily). This will give you the third leg of the tax-diversification stool. Since capital gains are (presently) taxed at a much lower rate than ordinary income – which is what your IRA or 401(k) distributions are taxed at – it makes a great deal of sense to have some of your money invested in these accounts as well.
Later in life…
Later on in your life, as you reach that point where you will have to begin taking Required Minimum Distributions (RMDs) from your IRA and 401(k) accounts, it might make sense to take significant portions of those accounts and either convert them to Roth accounts or capital gains taxed accounts. The preference would be to place the funds distributed into a Roth IRA, especially if you are in a position where you will not need access to the funds for some time and therefore can benefit from the tax-free growth of the account. But you may also want to balance those conversions to Roth with some non-tax-deferred investments as well – because you never know what may happen with the tax code.
It’s (very!) possible, given the government’s need to increase tax revenues to pay for things like the health care initiative, that there could be changes in the works for how tax-deferred plans are taxed. Just a few options that have been put forth in recent memory include:
- extra taxes on IRA assets (this was in place back in the mid-80’s)
- changes to the minimum distribution rules to require faster distribution or to eliminate “stretch” capabilities
- adding investment restrictions, such as requiring a portion of IRAs to be invested in “socially responsible” investments
- nationalization of retirement accounts – e.g., governmental takeover of all IRA and 401(k) plans in exchange for a superannuization plan like some socialized countries use
Yet another option, especially if you have very few assets outside your IRAs and 401(k) plans, you can reduce your taxable estate (when we have an estate tax again, that is) by taking extra distributions from your IRA or 401(k) and making gifts to your children and grandchildren. You could place the assets in a trust that represents a completed gift, or give the money directly to your future heirs – this way you are able to see your children and grandchildren enjoying the fruits of your labors while you’re still living.
Photo by alancleaver_2000
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