One of the first lessons of saving for retirement is to try to max out your 401(k) or individual retirement account (IRA), but some financial advisers are warning people not to put all their eggs in one basket.
If you have a limited amount of money to stash away for retirement, it’ll serve you better if you split that money into different types of savings vehicles, including brokerage and Roth accounts, they said.
Having different buckets to draw money from to fund your spending in retirement offers a lot of benefits, but the most notable one is tax savings, they said.
“You don’t want all your money in tax-deferred accounts,” said Daniel Razvi, senior partner and chief operating officer at Higher Ground Financial Group. “IRAs are the biggest scam in taxes today.”
Why’s having only 401(k)s and IRAs bad for your taxes?
- IRAs and 401(k)s are tax-deferred investments, which means the money you invest isn’t taxed until you withdraw the money, usually in retirement. The problem is we don’t know what the tax rate will be in the future, though it’ll most likely be higher, advisers said.
“Say, we start a business, and I put in 25%, you put in 75% and do more work,” Razvi said. “You don’t read the fine print of the contract like most people don’t, and 20 years go by, and the business is amazing. Now, I’m seeing the contract and realize I have the ability to change the percentage without your approval and take more. Would you enter a business deal like that? If your dollars are in an IRA, that’s the contract you have. The government decides 40 years from now what the tax will be at that time.”
- Money withdrawn from 401(k)s and IRAs is taxed as income. Income tax rates are generally higher than the long-term capital gains tax from a traditional brokerage account, advisers said.
“If you have a net worth of $2 million and $1.7 million is in IRAs, think of how trapped you are if taxes go up,” said Joseph Patrick Roop of Belmont Capital Advisors. “You only have an IRA and 401(k), and it’s all taxable.”
- Starting at age 73, you must take an annual required minimum distribution (RMD) and pay the taxes, whether you need the money or not. If RMDs boost your income enough, you could also hit thresholds that increase your Medicare costs and trigger taxes on more of your Social Security benefit.
“I love tax-deferred growth but are you tax-deferring yourself into higher brackets?” said Nicholas Yeomans, president and chief compliance officer at Yeomans Consulting Group.
- With the IRS’ new rules on inherited IRAs, you may also be passing on the tax burden to non-spouse beneficiaries, advisers said. The IRS requires most people who inherit IRAs to liquidate the account within 10 years of the original owner’s death, and in some cases require annual RMDs that could come during the beneficiary’s peak earnings years.
How can different types of accounts help lower taxes?
Roth, traditional brokerage and health savings accounts give you more control over your income and taxes, advisers said.
- Roth accounts are funded with after-tax money so withdrawals are tax free as long as you’re at least 59-1/2 and it’s been at least five years since you contributed to the account. RMDs also don’t apply to Roth accounts so you’re never forced to make withdrawals.
Most non-spouse beneficiaries of Roth accounts will have to liquidate the account within 10 years from the original owner’s death, but they don’t have to do so until the last year which allows the investment to grow until then. They also don’t pay taxes on the money.
- Brokerage accounts aren’t subject to RMDs and if you’ve held your investments for at least a year, withdrawals are taxed as long-term capital gains. Those rates of between zero to 20% depending on your income level are generally lower than income tax rates ranging from 0% to 37%.
Inherited brokerage accounts get a step-up in basis, meaning the account is adjusted to the current market value at the owner’s death. If immediately liquidated, there’s no capital gains tax to pay, Yeomans said.
- Health savings accounts (HSAs), pre-tax money you can set aside if you have a high deductible health plan to pay qualified health care expenses, can also be used for retirement savings. “You can choose to cover medical costs today, or invest and allow your contributions to grow, to cover future costs in retirement,” said Lauren Wybar, senior wealth adviser at Vanguard. If you keep your health care receipts, you can withdraw HSA money tax free against those qualified expenses during retirement. HSAs are triple tax advantaged, “where contributions and qualified withdrawals are tax free and investment growth is tax deferred,” she said.
A non-spouse beneficiary of an HSA account would have to liquidate the fund and pay the income tax the year the owner dies, though.
How should you allocate your money between accounts?
First, if your company offers contribution matches, always contribute enough to those accounts. “Never turn your back on free money,” Yeomans said. “That’s a 100% rate of return on your dollars. Get the full match.”
After that, advisers differ slightly on what to do. For example,
- Wybar recommends continuing to save between 12-15% of your income (including matched contributions) in your 401(k), or if you can, maxing out of the account given its tax-deferred benefits, before moving to HSAs. If you still have more money, traditional and Roth IRAs “give you flexibility to hold many different investments including any mutual fund, ETF (exchange-traded fund), stock, or bond—many of which might cost less than those offered through your employer plan.”
- Yeomans says a loose goal might be to save half your money in tax-deferred accounts, a quarter in Roth accounts and a quarter in brokerage accounts.
“Everyone always talks about asset diversification, but we need to focus on tax diversification because the future of taxes is unknown,” Yeomans said.
