Many people who set aside money for their retirement are focused on the dollar value of their investments. Contributions may be based on calculating what they need to set aside to live comfortably in their retirement. However, it is also important to consider tax diversification because you may not know how your tax bracket will affect your income levels after you retire. Moreover, there's a potential tax rates will be higher when you retire than they are currently.
Very few sources of income are tax exempt. These may include municipal bonds, academic scholarships, and gifts up to $14,000. Most other income is subject to taxation. However, with retirement planning investments, you may have the option to take advantage of income tax breaks on the money now or later. Depending on your current income and anticipated future income, it may make more sense to choose one investment strategy over another.
Many retirement plan options provide for tax-free contributions. This includes a 401(k), 403(b), SIMPLE IRA, traditional IRA, or SEP. These retirement plans generally have contribution limits, with catch-up contributions allowed for employees age 50 and older. If the total contributions exceed the deferral limit, the excess is included in an individual's gross income, subject to ordinary income tax.
A Roth IRA is funded with post-tax income, however, and withdrawals are made tax-free. Roth IRAs are also subject to contribution limits, currently $5,500 for single filers in 2016, with catch-up contributions of an additional $1,000 for individuals aged 50 and above.
If your future tax bracket is likely to be higher than your current tax level, you may want to pay tax on contributions now in exchange for tax-free withdrawals later. If your future tax bracket is expected to be lower, you can make tax-free contributions and your withdrawals will be subject to ordinary income tax. However, because of the uncertainty in your future tax level, tax diversification can temper any significant changes.
You may be able to make a prediction on your future income tax rates based on your investment goals and current tax rates; however, it is impossible to know for sure. Traditional IRAs and 401(k) plans have required minimum distributions (RMDs) beginning at age 70 ½. However, Roth IRAs do not require minimum withdrawals during the life of the owner, but the contribution limits are also significantly lower with IRAs and Roth IRAs than 401(k)s.
Major changes in your income level, stock market volatility or financial emergencies can alter your investment outlook. Additionally, the state or federal government may make significant changes to the tax code, affecting income tax rates, contribution limits, and tax exemptions.
Tax diversification includes utilizing both pre-tax and after-tax options for your retirement plan. Over the course of an individual's working life, a tax diversification strategy would include making contributions to both types of tax-preferred retirement plans. Individuals with significant changes to their income level year-by-year may be able to alternate between pre-tax and after-tax contributions.
If you have any questions about employee benefit plan options or tax planning for your retirement, Butterfield Schechter LLP is here to help. We will answer all your questions and ensure you have a diversified retirement plan in place to allow you to retire in comfort. Contact our office today with any questions on how we can help you and your family succeed.
*NOTE: Nothing in this article should be construed as individual tax or legal advice. Contact a tax advisor or attorney to discuss your specific situation.