Now that April 15 has come and gone, many Americans are beginning to evaluate their finances and start planning for the coming year. For those retiring in the next five to 10 years, there’s one important question to consider before finalizing your 2014 strategy: What’s your ideal tax balance for your retirement savings?
By “balance,” I mean the mix of pre-tax, after-tax and Roth retirement plan money in your retirement savings.
Whenever a pre-retiree walks through my door, the first thing I do is take an inventory of his or her assets and separate them into:
- A pre-tax bucket — 401(k) and traditional IRA
- A Roth bucket — Roth IRA, Roth 401(k) or Roth 403(b)
- An after-tax bucket — money that’s taxed annually, such as a savings account or investment portfolio
The right balance among these buckets can help your money work harder and smarter for you.
A good understanding of your current ratio among the three buckets — and how that ratio will change year over year — may allow you to develop a tax strategy to help ensure that you’re getting the most from your money during retirement.
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If you really want to leverage the tax law over the next 30 years, presumably during the peak of your retirement, you need to find the right financial balance among the three buckets.
Before you can do that, however, you’ll want to determine your effective tax bracket.
You probably know the marginal income tax bracket you’re in. But knowing your effective tax bracket — the percentage of your total income that you pay in taxes — is essential to assess how much of your retirement savings should go into each of the three tax buckets.
To get your effective tax bracket, divide your total taxes paid by your total taxable income. (If you hired a pro to prepare your 2013 taxes, ask that adviser to show you the difference between your effective and marginal tax brackets.)
You’ll likely find less money than your marginal tax amount is going to taxes, due to exemptions, deductions and credits.
Now that you’ve found your effective bracket, here are some questions you’ll need to answer to search for your ideal balance between the three tax buckets:
The Pre-Tax Bucket
Do I have too much pre-tax retirement savings for a rising tax world?
Most people hold the majority of their retirement savings in pre-tax accounts through employer-sponsored savings plans.
The problem with this is that it creates a lack of balance among the three buckets, which could put you at risk of paying additional taxes when you reach retirement.
When you withdraw money from your pre-tax accounts, it’s taxed as ordinary income; distributions from a traditional IRA will likely also be subject to a 10 percent tax penalty if taken prior to age 59 1/2.
(MORE: Smart Ways to Spend Your 2013 Refund)
There is no doubt that pre-tax retirement accounts offer a convenient way to save for retirement. In fact, the Voya Financial 2013 Retirement Experience study found that nearly all pre-retirees (94 percent) have savings in a workplace retirement plan.
But if your effective bracket is lower than 25 percent, and you think taxes could go up in the future (as many people do), you may want to contribute more towards a Roth. That’s because you don’t owe taxes on Roth withdrawals and your contributions would be taxed at today’s potentially lower rate.
If your effective bracket is greater than 25 percent, however, you may want to reduce your taxes now by contributing to a pre-tax account.
The Roth Bucket
Is it worthwhile to open a Roth retirement savings account?
Exploring the Roth is a good first step to better balancing your savings.
A Roth IRA, 401(k) or 403(b) account is often thought of as a “young person’s investment” because it generally has low investment minimums and benefits those who have more time to let investment gains grow tax-free. Yet, even if you are five to 10 years from retirement, opening a Roth can boost your retirement readiness.
Roth IRA To contribute the maximum amount to a Roth IRA for 2014 — $5,500, or $6,500 if you’re 50 or older — your income must be under $181,000 if you’re married filing jointly or under $114,000 if you’re single.
To qualify for a tax-free, penalty-free withdrawal, a Roth IRA must be in place for at least five tax years and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Roth IRA distributions may be subject to state taxes.
Roth conversion account This lets you convert pre-tax savings from a 401(k), 403(b) or traditional IRA to a Roth regardless of your income level. But you must pay taxes on the converted amount in the year converted. You may want to convert small, gradual amounts over the course of several years to reduce the tax burden. (Consult with financial and tax advisers before embarking on this strategy.)
Roth 401(k) or Roth 403(b) Here, there are no income restrictions and any person can contribute, as long as your employer-sponsored retirement plan offers the option. Only about one-third of employers offer Roth 401ks, but firms are increasingly adding this option. Ask your employer if this feature is available.
The After-Tax Bucket
What is the role of the after-tax savings bucket in retirement?
This bucket is made up of investments in mutual funds, stocks, regular savings accounts and the like — essentially savings that aren’t in IRAs or employer-sponsored savings plans.
This money is invested after-tax and you’re taxed annually on any interest, capital gains and dividends.
Finding the Right Balance
Finding your balance will take time and maybe a few rounds of shifting the way you contribute money among these different buckets.
Consider what your level of income and taxes will be during retirement.
Because you won’t be facing taxes on Roth withdrawals, those retirement accounts could be well-suited for “lifestyle” money that can fund nonessential, large purchases like cars, your house or vacation.
After-tax money that you can easily access from your bank savings or investment portfolio could play an essential role in retirement building your emergency fund, paying for large withdrawals (say for house renovations or a vacation) and helping with medical expenses.
Remember that your “right” balance may shift year to year as your life changes, and that’s OK. By working regularly with a financial adviser and tax professional, you can determine the best tax strategies to make the most of the money you’ve worked so hard to save and adjust them as needed.
After all, April 15 comes every year whether we want it to or not. Having the right balance could put you in a better position come tax day each year.
Securities and Investment advisory services offered through ING Financial Partners, Member SIPC. Please note that neither ING Financial Partners nor any of its agents or representatives provides legal or tax advice. For complete details, consult with your tax adviser or attorney.
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