This year, the unthinkable happened. A global pandemic forced many of us to stay home, change the way work happens, and most importantly, demonstrated the importance of a solid contingency plan.
Your retirement plan is the same as any other business operations or financial plan. Do you stay awake at night worrying about market conditions? Are you scared tax policies implemented by the government could hurt your ability to support you and your family in retirement? You should have back-ups and contingency plans in place for when surprises happen. There are a few factors you need to protect your retirement plan against, including rising taxes and uncertain market conditions.
What is the difference between tax-free and tax-qualified accounts?
Roth IRAs (including Roth after-tax contributions to 401k, 457, 403b) and traditional IRAs (including Pre-tax contributions to 401k, 457, 403b) differ in one key way: when and what funds are taxed. When you contribute to a Roth IRA, you’re investing post-tax dollars and are not taxed on that income when you make withdrawals in retirement.
On the other hand, traditional IRAs get a slight tax break up front, since you can deduct your contributions. However, you then have to pay taxes on all the money you pull out of the account.
Are taxes going up?
The United States’ federal budget deficit surpassed $3 trillion this year. The climbing debt in the United States will need to be repaid somehow, and, unfortunately, raising taxes will likely be the solution. It’s important to calculate how reduced income dropping you into a lower tax bracket in retirement and rising tax rates over the next few years will balance each other out.
When do you want to be taxed?
The goal of your retirement account is to grow your investment, so it’s logical to assume that what you’ll be pulling out of it once you hit retirement will be larger than what you’d initially invested. Wouldn’t you rather only pay taxes on the initial money you invested, not all the interest and gains earned too?
Let’s explore the math. Say you get a very generous bonus of $100,000 from work and are taxed an average of 20%. You’re left with $80,000 to invest in your tax-free retirement account. Earning an average of 7% each year, you’d end up with a total of $649,319 after 30 years and be able to keep all of it.
Now let’s say you invested the whole $100,000 bonus in a tax-qualified account and again left it to grow 7% each year. After 30 years, you would have $811,649. Unfortunately with inflation and substantial federal debt, you’re now taxed at a rate of 30%, leaving you with just $568,154.
Especially if you’re in a lower tax bracket now, it’s imperative that you take advantage of low tax rates and protect yourself from potentially higher rates down the road.
The Smart Money Order
When you begin investing in your retirement, we advise that you follow this smart money order, developed by Patrick Kelly, to get the most out of your money and best set yourself up for a successful retirement.
Start by taking advantage of any free money available to you for retirement. If your company offers a retirement plan match, contribute up to the maximum matching amount. You can defer your own money into the Roth bucket of your 401k, 403b, or 457 if your employer offers the Roth provision. The company match will go in the pre-tax bucket of your account.
From there, max out your tax-free accounts like your Roth IRA, Roth 401k, and life insurance policies.
Once you’ve hit your contribution limits for tax-free accounts, or if your income level prohibits you from contributing to those accounts, start investing in tax-deferred accounts like Traditional IRAs and Traditional 401ks.
Finally, your last investment choice should be taxable money. Wait until all other investment vehicles are exhausted before investing in these accounts.
By investing in this order, you’ll be able to shield your nest egg from taxes in retirement, optimize your income, and make the most of your investments.
The way we see it, there are 3 options. Keep planning for retirement the way you are now (bear in mind that this could subject you to significant market risk and tax law changes), carve out time and energy to research the marketplace to find solutions that avoid retirement risks, or contact an advisor.We’re here to help. Schedule a meeting to explore how we can help you optimize your retirement plan.