A common question my clients ask me is, “How much do I need to have saved at retirement?” If I had a crystal ball that could see into the future, the answe r to this question would be easy. I may not be a fortune teller, but my job as a financial advisor is to work with my clients to determine their goals, assess their current financial situation, and create a financial plan that will help them achieve those goals. Typically, after my clients ask this big question, I answer with a follow-up question: “What kind of life do you want to live in retirement?”
Everyone envisions retirement differently, and because you will primarily live off your retirement funds when you get older, your retirement goals will affect how much you need to save. Whatever your retirement goals may be, you want to get the most out of your hard-earned money so you can enjoy your golden years to the fullest.
One key aspect to maximizing your retirement savings lies in a strategy called tax diversification, which involves saving your money into different types of retirement accounts with different tax treatment to alleviate the tax burden over time. Proper tax planning and diversification of your assets could save you a significant amount of money in the long run. So, how does it work?
We all know taxes are inevitable, but how your retirement funds are taxed depends on the type of account into which your money is deposited. There are three main areas or “buckets” you can contribute to from a tax perspective when saving for retirement: tax-deferred, taxable, and tax-free.
Tax-deferred: In this bucket, the contributions – which may be tax-deductible – grow tax-deferred and are taxed at withdrawal. Things to consider with this savings strategy: distributions are generally taxed as ordinary income upon withdrawal, generally there’s a penalty to access funds prior to 59? years old, and generally distributions are required to begin at 72 years old.
Taxable: This category consists of funds that have been contributed with after-tax money, such as checking accounts, savings accounts, or brokerage accounts. There is no deferral of taxes, so when earnings are realized, you will be subject to taxes. Generally, this includes interest, dividends, and capital gains or losses.
Tax-free: This type of account consists of funds that can be invested with after-tax money. Earnings can be tax-free, provided certain conditions are met. Examples of these savings vehicles include Roth 401(k), Roth IRA, cash value life insurance, and municipal bonds (subject to capital gains at sale or maturity).
Leveraging these unique taxation buckets can benefit your situation by providing control over when and how much you take, flexibility in expected and unexpected life events, and sustainability that could help your assets last longer.
With any of these accounts, it’s best to start saving as early as possible – even if it’s just a small amount of money – so your funds can grow exponentially over time. As Albert Einstein said, “The most powerful force in the universe is compound interest.” If your employer offers retirement benefits, make sure to take advantage of the opportunity to further grow your account through matched funds.
It may seem tempting to put all your money into one type of account. During their working years, many people only want to do pre-tax, as it saves money on their current taxes. I understand this “one and done” strategy is appealing. But the point of tax diversification is to diversify where you deposit your retirement savings, because your income will likely fluctuate as you move up in your career – or change careers entirely. Life events like buying a home and having a baby will also temporarily pivot your savings strategy to accommodate current expenses.
Having your assets in different types of accounts provides you with flexibility on how you satisfy your income needs in your retirement years, and could allow you to payless in taxes over time and keep more of your savings.
As with any financial matter, there are always exceptions to consider when allocating your assets. That’s why it’s important to work with a financial advisor to navigate your options and determine the best tax diversification strategy for your unique circumstances. Financial advisors, like myself or my team members at TruStone Wealth Management, can help you determine the best balance for you. We also work with Certified Public Accountants (CPAs) to help ensure your tax diversification strategy meets all federal tax requirements.
Whatever your retirement goals may be, we are here to help you create a plan that will help your assets last longer in retirement, offer flexibility as your life unfolds, and provide some control over how you withdraw your funds, so your golden years truly stay golden.I'm here to help you feel more confident about your financial future.
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