By Some money management truths are self-evident: Always set aside enough cash for emergencies. Diversify your portfolio. And maximize your contributions to tax-advantaged accounts such as a 401(k) or IRA.
The Tax Dilemma
That last one is open to debate. Even if you like the idea of cutting this year’s tax bill by funding your 401(k), you will eventually owe the federal government some money — and probably more than you expect.
“There’s a general consensus that tax rates will not be going down in the future,” said Craig Eissler, a Houston-based certified financial planner. Nevertheless, he urges clients in a high tax-bracket to reduce their current taxable income by maximizing tax-deferred contributions. “Then in retirement, you can pull out money from different buckets, like a taxable brokerage account or trust, not just from your tax-advantaged account,” he said.
The Future of Taxes
Experts warn that tax rates will need to increase at some point to plug the federal budget deficit and fund Medicare and Social Security. Pre-retirees who diligently max out on their 401(k) contributions every year will probably face higher ordinary income tax rates in the future.
The likelihood of steeper tax rates in the coming decades might lead you to rethink traditional advice to stash every dollar you can into tax-deferred vehicles. While it’s a great deal if your employer matches your contributions, there are some situations where it’s actually prudent not to max out your 401(k).
A Different Approach
For example, some pre-retirees can come out ahead by buying more equities in their taxable brokerage account rather than maximizing their annual 401(k) and IRA contributions. Many variables come into play, such as their current tax bracket and investment savvy.
Retirees Can Take Advantage of Lower Taxes on Capital Gains
When planning for retirement, it’s important to consider the tax implications of your investment choices. Financial advisers are now recommending a strategy that involves shifting some funds from 401(k) accounts into taxable brokerage accounts to take advantage of lower capital gains taxes.
Typically, individuals in their late 40s and 50s are advised to contribute as much as possible to their tax-advantaged 401(k) accounts. However, advisers like JR Gondeck in Boca Raton, Fla., suggest a different approach. By moving some funds into a stock index fund within a taxable brokerage account, retirees may be able to reduce their tax burden in the long run.
Gondeck explains that while retirees might face a hefty 40% tax rate when they withdraw funds from their 401(k), they could potentially owe only 20% in taxes on the sale of equities if current capital gains rates remain steady. This stark difference between ordinary income rates and capital gains rates can make a significant impact on retirees’ overall tax liabilities.
The shift in strategy is particularly relevant for those approaching retirement age. In earlier years, deferring taxes through a 401(k) is often advised. However, as individuals enter their late 40s, the focus shifts to balancing tax deferment with capital gains to avoid excessive tax bills during retirement.
Another aspect of achieving balance during retirement planning is dividing funds between tax-advantaged and taxable accounts. Ideally, high earners should contribute to both types of accounts. However, some individuals may find that their tax-deferred accounts are overfunded while their taxable accounts are relatively meager.
Patrick Dinan, a certified financial planner in Glendale, Calif., points out that this imbalance can create problems later on. If the majority of an individual’s net worth is tied up in a 401(k) by age 70, they may face a substantial tax burden.
It’s important for pre-retirees to understand the benefits of diversifying their retirement savings across both tax-advantaged and taxable accounts. By making strategic investment decisions and planning for the long term, individuals can take advantage of potentially lower capital gains taxes in retirement.
Additional Resources:
- That 401(k) match isn’t just free money, 3% could buy you two years of retirement
- We know not to take money early from a tax-deferred retirement account. So why do we do it?
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