There are so many types of savings accounts out there. How can you choose the right mix of accounts with which to enter retirement?
Most people understand the importance of diversifying their investments. By allocating funds to different asset classes like stocks, bonds, and alternatives, you can potentially reduce your risk of a negative outcome from any one event or investment.
But did you know you can also have some control over how your savings are taxed?
By allocating money to a mix of accounts that offer different tax treatments, you can manage how much of your retirement income will be taxed — and at what rate. The key is to select an optimal mix of accounts. You have several types to choose from, so consider working with a financial advisor to choose the right combination for you.
Taxable accounts are your standard bank and brokerage accounts funded with after-tax dollars. You will pay income tax on any interest or dividends earned during the year.
If you sell any investments for a gain, you may pay capital gains taxes. Those can potentially be offset with losses incurred from security sales (up to a certain amount).
While the earnings in these accounts are taxed each year, you have the freedom to contribute or withdraw funds without limitation or penalty. Also, these accounts are exempt from required minimum distributions (RMDs), which means that you are never forced to withdraw money regardless of whether you need it.
Traditional IRAs, 401(k)s, and 403(b)s are all tax-deferred accounts. The contributions you make to these accounts can reduce your taxable income in the year they were made (provided that your income meets certain requirements).
Unlike brokerage accounts, these accounts are funded with pre-tax dollars. Your contributions and any investment gains are not taxed until retirement. This allows the account balance to grow without taking anything away from the principal.
Once you retire, any money withdrawn from traditional IRAs, 401(k)s, or 403(b)s is taxed at your ordinary income tax rate. For many people, that tax rate in retirement is lower than it was when they were working.
You will also be required to take out annual RMDs from your tax-deferred accounts once you reach the age of 72. You will have to pay ordinary income tax on your RMDs, as well.
While traditional IRAs are funded with pre-tax dollars, Roth IRA contributions are made with after-tax dollars. So, those contributions won’t reduce your taxable income in the year the contribution is made.
The good news is that money withdrawn from your Roth in retirement is not subject to taxes — no ordinary income tax, no capital gains — as long as you follow timing requirements. Also, Roth IRAs are not subject to RMDs during the account owner’s lifetime. That leaves you free to tap Roth accounts when you need the money — and let them grow when you don’t need the withdrawal.
Health savings accounts are not usually thought of as a retirement account, but they offer a valuable (and potentially tax-smart) way to save. However, you can only open an HSA if you are covered by a high-deductible health plan.
Contributions to an HSA reduce your taxable income up to the annual limit. And like an IRA, your investments grow tax free. You can also withdraw money tax free at any time for qualified medical expenses.
This means an HSA offers a triple tax benefit — you can reduce taxable income during the years you make contributions, your savings grow tax-free, and you have the path to pay medical expenses with pre-tax dollars.
After age 65, you can use any funds remaining in your HSA for medical expenses that are not covered by your insurance or Medicare. You also have the option of using your HSA funds to pay non-medical expenses, but those withdrawals may be subject to ordinary income tax.
The key to minimizing taxes on your retirement savings is to choose the right account mix for your contributions — and to get your timing right. Each type of account has different rules about participation ages, contribution limits, investment limitations, RMDs, and more. Those rules change as Congress passes new legislation and tax laws. So, no matter what tax strategy you choose, it is important to review it every few years with a financial professional. With careful planning, you can diversify your tax bill — just like you do your investments.
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