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The Smart Way to Pay Taxes on Retirement Savings

By LifeYield | April 1, 2017 | Social Security Advantage

Don’t pay all at once–and use these tips to increase your nest egg.

Kathy Kristof
April 2017 Issue: https://www.inc.com/magazine/201704/kathy-kristof/retirement-savings-taxes.html

Tax season is complicated enough without your having to worry about retirement planning. But if you want to maximize your future spending money, this is exactly the right time to review the taxes you’re paying–or not paying–on what you’re saving.

Just ask Phil Holthouse, co-founder of Los Angeles accounting firm Holthouse Carlin & Van Trigt. You should never “let the tax tail wag the investment dog,” he says, but that doesn’t mean you should ignore the issue, either. “No one wants to pay more than the law requires, but a lot of people do,” he says.

Structuring your retirement accounts with taxes in mind can land you hundreds of thousands of dollars more in spending power. And it can ensure that you have the right amount of money at the right point in your retirement.

Preparing financially for life after work requires different strategies over the course of your career. You’ll start in the early “poor but smart” stage, when tax breaks can help you save more, and eventually graduate to the “fabulous 50s,” which many believe are your prime savings years: You’ll be earning more and should have already paid for big expenses, like your house and college for the kids. To pay the least tax in each of these periods, you’ll need to diversify your savings–and your tax burden–right now, so that you’re spreading out what you pay on it.

In brief: Put some money into regular brokerage accounts, which are taxed on a more immediate basis than retirement accounts; put some money into tax-deferred retirement accounts, such as traditional 401(k)s and SEP-IRAs, which allow you to reduce the income taxes you pay right now; and don’t forget to put some money into tax-free retirement accounts, such as Roth IRAs, which allow you to withdraw money later without paying taxes on it.

How much to put where, and when, varies for everyone, of course, but this three-step primer can get you started on a smart retirement tax strategy.

Step one: Start out with traditional retirement accounts

Think 401(k)s, SEP-IRAs, and Roth IRAs. When you’re just getting your business off the ground, you probably believe you don’t have a lot of money to set aside for retirement. But actually, this is exactly when you should be taking advantage of tax breaks for your retirement planning. At this stage, investing in a tax-deferred retirement account like a 401(k) puts more money in your pocket and allows you to boost your savings rate.

Consider two hypothetical 30-year-olds, John and Jane, who both earn $110,000 annually and are in the 28 percent federal income tax bracket. John contributes $1,000 a month to an ordinary brokerage account, for which he pays annual taxes on his investment earnings. But Jane puts the same amount into a SEP-IRA, a retirement plan for self-employed individuals that allows her to deduct these contributions from her taxable income. So the federal government acts as if she had earned a lower income than John, which cuts her federal tax bill by $3,360 annually. (If she lives in a state that imposes income taxes, her tax savings are even greater.) Jane can go a step further and put that $3,360 into a Roth IRA. (Such accounts are available only if your annual income is under $133,000 when single, or $196,000 when you’re married and filing jointly.) When she eventually retires, she won’t have to pay taxes to withdraw money from that Roth IRA. And if she puts the same amount away every year, assuming average annual stock market returns of 8 percent, she could wind up with an additional $640,000 or more in retirement savings by age 65.

Step two: As you get older and richer, add a taxable brokerage account

It may sound counterintuitive, but you should put more money into taxable accounts as your wealth increases. For example, Holthouse advises his clients to put additional savings in a nonretirement brokerage account when they’re older and earning more. Don’t stop contributing to traditional retirement accounts, of course–but recognize that they come with some drawbacks that regular investment accounts don’t have. And that makes it wise to have both. Specifically, you’re subject to tax penalties if you withdraw money too soon–or too late–from taxdeferred retirement accounts. Uncle Sam usually imposes penalties on nonretirement withdrawals before age 59½ and for failing to make withdrawals by your early 70s. Even if you start tapping your retirement accounts right on schedule, you’ll have to pay ordinary income taxes on whatever you take out of them. (This applies to all so-called qualified retirement plans, including 401(k), 403(b), IRA, SEP-IRA, and Keogh accounts.) Those federal tax rates can climb as high as 39.6 percent, depending on how much income you report in any given year, including what you pull from these retirement accounts. But with a nonretirement investment account, you are taxed only on your earnings, not on the principal you originally invested–and your gains are generally taxed at lower rates than ordinary income. Capital gains rates top out at 23.8 percent for the highest-income filers, and can drop to zero for those whose federal income is taxed at rates of 15 percent and lower.

Step three: Remember to diversify your assets, not just your accounts

Asset allocation is the art of deciding how much of any given investment–stocks, bonds, cash, real estate, etc.–you should hold. That’s best done with a financial planner, who can match your risk tolerance and time horizon with the right investments. Asset location is the art of putting those assets in the right type of investment and retirement accounts.

Jack Sharry, executive vice president of financial software provider LifeYield, says you can boost after-tax returns by 1 to 2 percentage points annually by getting those locations right. His general advice:

• Put most of your stock index funds in the likes of savings and brokerage accounts, which are taxable now. They enjoy lower capital gains taxes and tend to throw off minimal income (from dividends) each year. These accounts also allow you to deduct capital losses when the market drops, and will result in your paying less tax when you pull money out to spend in retirement.

• Put bonds, REITs, and other investments that yield regular interest income in retirement accounts, such as 401(k)s and IRAs, which defer tax until withdrawal.

• Put higher-risk and potentially higher-return investments–think small-company and emergingmarkets stocks–in Roth accounts, which allow you to withdraw money tax-free. Because these investments have the potential to earn the most, you want to minimize the taxes you’ll pay on them.

There’s no one right answer for all of this. But spreading around your retirement investments, and spacing out the taxes you pay on them, can effectively hedge your saving strategy–and ensure that you have enough money for everything you want to do in retirement. “A lot can change over the decades before and during retirement, so I don’t stress too much about getting this exactly right,” Holthouse says. “But even getting it directionally right can save you a ton of money.”

Your Tax Timeline

Divide up your retirement savings into these three types of accounts.

Pay now

Taxable accounts are simple savings and brokerage accounts, which report any income you’ve received over the course of the year to tax authorities. You pay tax on dividend and capital gains income in the year that you receive it.

Pay later

Tax-deferred accounts are those set up within a qualified retirement plan, including 401(k) and 403(b) plans, as well as traditional and SEP-IRAs. Contributions to these accounts are taxdeductible when they are made, and no tax is due on accrued earnings in an account until the money is withdrawn at retirement.

Pay never

Tax-free accounts are Roth IRAs and Roth 401(k)s, which do not allow you to claim deductions for your contributions. But when the money is used for retirement, withdrawals are generally exempt from tax. https://www.inc.com/magazine/201704/kathy-kristof/retirement-savings-taxes.html