If you are approaching retirement in the next 10-15 years, you are reaching a window where you need to be intentional to prep your retirement savings. This doesn’t just apply to how much you’re saving – equally important is the financial tools you’re using to structure your retirement income.
One of the primary factors that help you decide which tools you’re using is how your savings will be taxed. You may have heard these called “the three buckets”, each representing how different retirement assets are taxed. Your three savings buckets include tax-deferred, tax-free, and taxable accounts. Once you know how they work, you can begin to make more informed decisions about how each can help you maximize your savings in retirement.
Bucket 1: Tax-Deferred Accounts
Tax-deferred accounts provide tax deductions when you contribute. These investments grow tax-free yearly, and withdrawals are subject to standard income tax as your salary would be. The amount you have in tax-deferred accounts, like your 401K, you pay 30% to 40% in taxes when you make withdrawals.
You can decide whether you’ll make pre-tax and Roth contributions; understand that those in high-tax states already contribute pre-tax. Some IRAs are tax-deferred, but the only way to get pre-tax funds into them is if you don’t have an employer retirement account or your income is below the threshold. You can get after-tax money into a tax-deferred account in an IRA, but the portion of the withdrawal from the tax-deferred account that is after-tax will not be taxed, as per the prorate rule.
Bucket 2: Tax-Free Accounts
With tax-free accounts, your contributions may or not offer a tax deduction. The accounts’ investments will grow tax-free yearly, and withdrawals will be tax-free. There are three common ways to get money into tax-free accounts:
After-Tax Contributions to a 401K
These contributions should be converted to the Roth sub-account immediately, leaving both contributions and earnings safe in a tax-free Roth account.
Backdoor Roth IRA Contributions
A “Backdoor Roth IRA” is a strategy used by high earners for converting a traditional IRA to a Roth IRA. This is commonly use for individuals that have an income that exceeds the Roth IRA income limits.
Contributions to a Health Savings Account
While these tax-free withdrawals only apply to health care expenses, you will probably need them for precisely that in retirement years.
Bucket #3: Taxable Accounts
When contributing to taxable accounts, there are no tax deductions. Each year’s income made from investments is subject to capital gains taxes. Upon selling investments, you then owe capital gains taxes on the gain at that moment. Getting money into taxable accounts usually occurs in one of two ways:
Company Stock Plan Deposits into a Brokerage Account
These deposits are in your name at one of the more popular firms like Fidelity, Schwab, and Morgan Stanley. If your company is public, this is RSUs when vested, ESPP shares when purchased at the end of the purchase period, or when options are exercised.
You Invest Your Money into a Brokerage Account
This can happen through a robo-advisor like Betterment, a crypto account like Coinbase, a stock-trading app like Robinhood, or a traditional firm like Schwab and Fidelity, where you choose your stocks or funds.
Why are the Three Buckets Important?
We haven’t merely shared this information to help you brush up on personal finance. There are real benefits to you now and later, including:
Your Tax Savings Today
The most important reason to contribute to a tax-deferred account is that you get a tax deduction NOW, reducing your current tax bill. This may be advisable as a tactic to manage your current tax bracket.
Managing Your Retirement Tax Burden
Your investments are designed to provide your future income, but you still want to control your taxes. While you’ll be getting Social Security income by the time you reach seventy, your income determines how much of that income is taxed and how much Medicare Part B premiums will cost you.
You can control AGI, having a lower AGI and minimizing tax rates and surcharges. And it’s something to consider when you contribute to all three of the accounts mentioned above, especially when tax-deferred and taxable accounts add to your AGI.
Ready to Create a Tax-efficient Retirement Plan?
If you’re ready to take this knowledge and update your retirement plan, we’re here to help. MOKAN Wealth Management specializes in turning your stack of statements and diversified pie chart into a tax-efficient retirement plan that helps you keep more of what you’ve worked to save.