Most people know that saving for retirement is critical. “Save early, save often” is a phrase that’s often touted when speaking with people in the beginning or middle of their careers. Financial advisors and nearly every article available about financial tips to get ahead talk about the importance of saving for retirement for a long period of time to allow funds to grow. However, the advice often starts and ends there. There’s little guidance available at first glance about taxes on retirement accounts, or where to save your money to maximize it when you retire.
There are a wide variety of account types that can help you to save for retirement. From a traditional workplace 401k to an individual investment account, you have many options available to you to grow your wealth before leaving your career.
However, understanding how those accounts are taxed can help you to increase the value of your savings and develop a more holistic retirement savings plan. In general, there are two types of tax classifications for retirement accounts - tax-deferred and tax-exempt.
Savings or investment accounts that are tax-deferred mean that they are funded with pre-tax dollars. In other words, the money you funnel into these accounts doesn’t count against your total taxable income, and you don’t pay taxes on it for the time being. Keep in mind that although these accounts are funded with pre-tax dollars, they are not tax exempt. You will pay taxes on account distributions when you retire. Those funds grow in your account until you retire. Then, when you take money out of the account (this is called a distribution) you pay taxes at whatever tax rate you are in during retirement (your ordinary income tax rate).
Savings or investment accounts that are tax-exempt are funded with money that has already been taxed. The funds grow over the years until you retire, and when you take distributions you don’t pay taxes on the money you withdraw. While these types of accounts don’t offer tax advantages by lowering your taxable income now, they reduce the amount of taxes you’ll pay in retirement.
If you’re looking for an easy way to remember which accounts fall into this category, know that anything “Roth” grows tax exempt once the funds are deposited. Investments purchased with after-tax funds provide for gains and losses within the account - which are never taxed as long as you comply with the regulations for holding a Roth account.
Another way to save for retirement may be in a traditional brokerage investment account. This account has no tax rules for a holding period or distribution age. Gains on investments bought with after-tax funds in this account will be taxed at a capital gains rate on your annual tax return. Gains are calculated as the sales price of the investment when sold, less what you paid for it. Losses can offset gains for tax purposes, and gains can be taxed differently if they are held less than 366 days (short-term) or more than 365 days (long-term). It’s also important to note that any dividends or interest paid from these accounts are taxable when earned - not when you take them as cash.
Let’s look at which common savings accounts fall into each category.
In a perfect world, everyone has the ability to leverage a combination of tax-deferred, tax-exempt and taxable retirement savings accounts. Using tax-deferred accounts can reduce your taxable income now, and save you money that can be put toward more immediate financial goals. Leveraging tax-exempt accounts can help your funds to grow tax-free, and to reduce the total amount of taxes paid in retirement. And using taxable accounts will also provide a source of income in the future, taxed at different rates. Taking income from all sources may be a way to manage tax rates during retirement.
Finding a balance to leverage all in your financial plan can be a challenge, but working with a financial advisor can help. If you have questions about your retirement strategy, or when to use different types of accounts, we’d love to talk. Reach out to us by clicking here.
Wood Smith Advisors, a woman-owned Registered Investment Advisor (RIA), is a fee-only financial services firm that partners with its clients to simplify their financial lives. We focus on women, entrepreneurs, and individuals with complex financial situations, providing objective and competent advice, education and services to help them develop and build their businesses and reach their financial goals. We can be reached by clicking here.
"Finance Made Simple" blog posts are intended for educational purposes and not for specific advice. Each person’s situation is different. Consult your financial advisor for advice relating to topics discussed.