Taxes are one significant uncertainty you’ll face throughout your lifetime. Whether you’re working or in retirement, your income will come under scrutiny for tax purposes. Taxes take a huge cut into your finances; however, there are several opportunities that you can leverage to lower the effect of taxes on your long-term financial plan.
Most people think they’ll stop paying taxes once they retire. Many financial experts also take on this view and have led numerous people to defer much of their income to pre-tax retirement accounts like 401(k) accounts or traditional IRAs. The reverse is the case, as withdrawals from these pre-tax retirement accounts are subject to tax in retirement. This often takes most retirees by surprise and affects their plans. You’ll also be required to take Required Minimum Distribution (RMD) on your real taxable income.
From a psychological point of view, it’s comforting to know that your asset is worth the value it’s tagged at and that you don’t have to plan a staged liquidation in retirement. Here are three significant reasons why after-tax accounts like IRAs and Roth accounts can benefit you.
Enjoy Lower Tax Rates
Taxes are currently at one of the lowest rates we’ve seen for centuries. This means paying your taxes now instead of deferring the process until years later may be the best strategy. It even makes more sense if you’re able to invest in a Roth 401(k) via an employer plan or a Roth IRA at a discount brokerage.
Roth accounts mean the money has already been taxed, so there are no expectations for taxes in the future. This provides a huge opportunity in terms of planning. These accounts don’t have a required minimum distribution (RMD) at any age, and money can be transferred to a beneficiary without tax consequences.
While we can’t predict how the tax situation will turn out after the November 2020 elections, we can draw some conclusions. The current tax policy is scheduled to sunset in 2025, and there’s a possibility that if Donald Trump is reelected, the tax brackets might increase. It seems beneficial to clear the taxes for as much income as you can now with this in mind.
Your 401(k) Isn’t All Yours.
Unlike Roth accounts, 401(k) accounts contain a significant share of deferred taxes and withdrawals and are taxed at the normal income tax rate, regardless of when it happens. There’s also a 10% penalty if you withdraw before the age of 59 and a half.
This means individuals with a million dollars in their 401(k) account isn’t technically a millionaire, given that a percentage of the money will be paid to the IRS upon withdrawal. By contributing to Roth accounts, you’re potentially eliminating the sting of paying potentially higher interest in retirement.
Paying Now Will Always be Better
There’s always the possibility that the tax rate may decrease in the future. In that case, it will be better to defer taxes. But do you want to take the risk? When you invest in Roth and taxable accounts, you can comfortably say you own the money, and you can plan for your retirement more effectively.
The psychology of not owing is priceless. It brings about peace of mind. By paying your taxes now, you avoid future complicated rules, as well as legislations that may inevitably affect tax-deferred accounts.
Try a Hybrid Approach
While the next few years until 2025 present a massive opportunity to maximize tax efficiency in your portfolio, if the uncertainty with taxes is too much for you to bear, then consider tax diversification. This means keeping some retirement assets in pre-tax accounts and others in tax-deferred accounts. This acts as an edge in case of a tax increase or decrease – so you get to win both ways.