“Many people investing in retirement plans, such as 401(k), 403(b) and IRAs, don’t fully understand tax-deferred investing.”
A recent Forbes article asks the question, “Want To Cut The Taxes In Your Retirement Money?” Who doesn’t? What are some of the major tax issues related to retirement planning and investing?
We should begin by looking at how your money gets taxed, if it’s not in a tax-deferred account. Investments like CDs that are held at a bank or brokerage firm are considered short-term investments. These investments are taxed as a short-term gain at your marginal tax rate, which could be as high as 39.6%. If your gain is considered a long-term gain, then it is taxed at long-term capital gains rates, which could be as high as 20%.
For your retirement savings, you can use tax-deferred investments such as a 401(k) or an IRA. For these investments, the government doesn’t tax your savings when you deposit it, and you’re not immediately taxed on any gains you make. Instead, the money can accumulate much more quickly and grow to much larger account balances, since you’re not paying taxes on your investment (at least until you withdraw it). If you participate in a company-sponsored retirement plan, such as a 401(k) or 403(b), you may save up to $18,500 annually. If you’re over 50, you can put away an additional $6,000 annually as a “catch up” contribution. A traditional IRA only lets you contribute $5,500, with an additional $1,000 for the over 50 “catch-up” contribution.
Unlike a taxable account (such as a CD), where you have the possibility of short or long-term gains, all future earnings, (including the savings in a 401K or IRA that never got taxed) will be taxed at your future income tax rate, when the money is withdrawn. You must be mindful of the withdrawal rules or face some significant financial penalties. For 401(k) or IRA accounts, with limited exceptions, you cannot withdraw funds before age 59½, without triggering a 10% penalty. Later, at age 70½ you must begin withdrawing Required Minimum Distributions (RMDs), or pay a 50% penalty on the amount you should have taken. Note: you must pay income taxes on any amount you withdraw from these retirement accounts.
A Roth IRA or Roth 401(k) are different from their traditional cousins, because your contribution is taxed today. In other words, your contribution dollars are post-tax as opposed to pre-tax like 401(k) or IRA contributions. However, similar to a 401(k) and IRA, your investments earnings are not taxed, and neither are your withdrawals.
Roth IRAs and Roth 401(k)s allow you to withdraw your money without tax or penalty starting at 59½. However, unlike the 401(k) and traditional IRA, you don’t pay taxes on the gains (you paid taxes on your original savings when it was deposited into the Roth). There are penalties for withdrawals before age 59 ½, but if you don’t pull more out than you contributed, they don’t apply.
There are many different investing strategies that are contingent on whether you’ll be taking money out as taxable or tax-deferred. There are certain investments that generate more gains than others. You can see that taxes can take a big bite out of whatever you make. The penalties for spending money in tax-deferred accounts before age 59½ can be huge, so consider taxes as part of your investing strategy.
Reference: Forbes (August 10, 2018) “Want To Cut The Taxes In Your Retirement Money?”