When it comes to saving for retirement, the phrase “Don’t put all your eggs in one basket” applies to diversifying not only your investments but also the structure of your savings.
Instead of putting all of your nest egg in one retirement bucket such as a 401(k), consider contributing to a few types of accounts, such as a traditional 401(k), a Roth 401(k), and a brokerage account. This diversification can potentially reduce the amount of taxes you owe in retirement while providing you with more flexibility when withdrawing your savings.
Why Saving in Only a Traditional 401(k) or IRA Can Be Risky
Historically, financial planning advice had been to maximize your tax-deductible contribution to a traditional 401(k) or IRA, with the premise being that you’re in a higher tax bracket during your working years, but you’ll be in a lower tax bracket in retirement as you draw on a lower annual income to cover your expenses.
However, this advice may not apply by the time you retire. Under the Tax Cuts & Jobs Act, the top tax bracket sits at 37%, down from the previous level of 39.6%, and far below historical rates. Not only are these personal income tax rates set to expire at the end of 2025, but a realistic look at the ballooning federal deficit indicates that raising taxes could be very much on the table in future political cycles.
That means that if you take the tax deduction now by saving in a traditional 401(k) or IRA, you could pay a higher rate when you take the money out in retirement, especially if you need to take out a large sum at once, such as for a family wedding or another significant expense.
Instead, if you’re eligible to invest in a Roth 401(k) or Roth IRA, you could end up paying more in taxes now but less in retirement and less overall, especially if tax rates increase.
Diversify with Different Buckets
Since it’s unclear where tax rates will land, you can reduce your tax risk by splitting your investments across different accounts.
For example, if your employer offers a Roth 401(k), you could contribute up to the maximum there (for 2019, $19,000 + a $6,000 catch-up contribution for those 50 and over). And since any employer match or contribution is required to go into a traditional 401(k), you would automatically have two buckets of savings.
You can make a Roth 401(k) contribution regardless of your income level, unlike Roth IRAs, which limit contributions for high-income individuals. Unfortunately, not every employer offers a Roth 401(k) feature. Adding a taxable brokerage account to your tool kit allows you to take advantage of lower tax rates on dividends and capital gains (under current tax rules) plus tax loss harvesting if or when you incur investment losses in your taxable account.
With such an approach, if your taxes are lower in retirement, you would benefit from having at least some money in a traditional 401(k). Conversely, if taxes are higher in retirement, you could withdraw primarily from your Roth account, and you’ll be glad you already paid taxes on that balance when rates were lower.
Keep RMDs and Eligibility in Mind
Since traditional 401(k)s, IRAs, and Roth 401(k)s have required minimum distributions (RMDs) once you turn 70 ½ based on your account balance and life expectancy, you’ll have to withdraw a certain amount every year.
These RMDs can adversely affect your tax strategy, which is why it’s important to diversify with different buckets. A Roth 401(k) can be rolled to a Roth IRA at retirement to avoid Roth 401(k) RMDs and provide more flexibility. Also, keep in mind that distributions from a Roth 401(k) or a Roth IRA are subject to a five-taxable-year period rule, so contributing early is beneficial.
For example, an RMD from your traditional 401(k), combined with Social Security and other income sources such as from a pension, could cause you to fall into a higher tax bracket. However, if you have your savings split among, say, a traditional 401(k), a Roth 401(k), and a taxable brokerage account, you would have more flexibility to minimize income taxes.
As such, having other account types such as a brokerage account, while taxable, could provide flexibility to save more and withdraw only what’s needed in retirement to keep taxes low.
There’s no universal strategy for splitting your savings across different buckets, and your strategy will depend on your circumstances and expectations for future tax rates. However, diversifying can be an important step toward minimizing your income taxes in retirement.
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