Investing for Your Retirement and Avoiding Uncle Sam’s Tax Booth Part 1 of a Series

By Aaron Bates, CFP, Investment Advisor

April 15, 2016

Each investment decision you make comes with some sort of tax impact. Therefore, saving for retirement can be as much an exercise in the tax code as it is in the financial markets.   You must succeed in both areas to enjoy the retirement income that you are looking for. The tax impact starts when selecting which account type you plan to use to hold your investments. There are three main types of accounts to choose from: taxable, tax-deferred and post-tax (Roth) accounts. None of these accounts have an investment advantage as most investments can be held in any of these account types. The intended use of the money in the account does have a significant impact on which account you select.

A taxable account is perhaps the most common type of investment account. These accounts can be registered to an individual, joint owners or to a Trust.   Deposits and withdrawals can be made at any time and for any reason. There are no limits on deposit and withdrawal amounts. Taxable accounts report interest, dividends and capital gains realized at the end of each year to the registered tax payer. The main advantage of a taxable account is its flexibility. The drawback is that you may end up paying taxes every year, depending on the types of investments you own in the account.

Tax-deferred accounts come in different formats but all of them allow deposits or contributions before income taxes are assessed. Some are funded directly and others are funded through an employer. These accounts include traditional IRAs, 401ks, 403bs, 457s and deferred compensation plans. The primary benefit of a tax-deferred plan is the reduction in income taxes when the account is funded. Assuming that working adults are in a higher tax bracket than retired adults, this can be a huge current benefit. Secondly, tax on interest, dividends and capital gains are also deferred from tax. This all adds up to an account that may have great compounded growth without any taxes being assessed on the account for many years. The tradeoff comes when distributions are taken in retirement. All distributions are taxable in the year they are taken. If tax rates are lower during retirement than your working years this can be a good thing, but future tax rates aren’t a given, so this is an assumption. However, this is a great way to accumulate retirement funds.

Post-tax accounts offer tax free growth on assets but all contributions are after current income taxes are paid. These accounts are most commonly known as Roth accounts. Like tax deferred accounts, they can be owned directly as Roth IRAs, or through an employer as Roth 401ks and Roth 403bs. Tax free growth is more desirable than tax deferred growth but sometimes the current income tax is just too much for some taxpayers. Once the contribution is made, and if the assets are held until retirement at age 59 ½, the gains will not be taxed. This presents a great option when retirees start drawing funds and they are tax free.

All three of these account types are valid tools to save for retirement. Taxable accounts are great for investors who want maximum flexibility. Roth accounts are most suitable for younger investors in a lower current income bracket who have lots of years to grow their investments.   In contrast, tax-deferred accounts may help reduce tax now for individuals in tax brackets 25% and up, with fewer years before retirement. If the funds you are saving are truly for retirement we highly suggest the tax-deferred or Roth accounts to avoid Uncle Sam’s tax booth as best you can. Please consider all your options and plan for your own objectives accordingly. We are happy to assist you if you’d value a second perspective.

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MadelineWarlow at 3:08pm EST - January 4, 2020


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