Retirement Savings and Taxes: Protecting Your AssetsPosted on August 25th, 2010 William No comments
One of the major considerations in deciding how to allocate your retirement funds is the tax treatment each retirement vehicle receives. Which tax treatment is best for you depends on a number of factors, but it basically boils down to one question: is it more important to not be taxed now, or to not be taxed later?
Tax-advantaged retirement plans generally fall into one of two categories. Either you are allowed to invest with pre-tax dollars, or you don't pay taxes on the earnings. Let's take a look at the advantages of each.
The traditional retirement savings plan, a 401(k), allows you to invest pre-tax dollars. This is nice because you get to earn a return on the money the government would normally be taking in taxes; in effect, you've just taken out an interest-free loan from the government. For example, if you were to put off paying $1000 in income taxes for 36 years, at an annual return of 10%, you'd get back $32,000. You now have to pay taxes on the full $32k, but that's still tens of thousands of dollars that you wouldn't have had otherwise. The 401(k) and similar arrangements make the most sense when you are currently in a high income tax bracket, as the immediate tax savings can be significant.
A Roth IRA and similar accounts are funded with after-tax dollars, but then they grow tax-free. These are particularly nice for people with fairly low incomes who expect to be earning more money later in life, as they can pay very little tax on the money now and no tax on the earnings later. While you should always fund your 401(k) to the limit of any matching funds your employer offers, we recommend that young investors then wait to put any more money into their traditional 401(k)s until they have fully funded Roths, because the longer time that the money will be invested amplifies means the withdrawals will be much higher than the initial deposits, so it makes more sense to avoid paying taxes when the money is disbursed.
While those are the two extremes, there are also a number of financial products that fall somewhere between the two. Annuities, for example, allow you to defer taxes on the earnings like a 401(k), but are funded with after-tax dollars like a Roth. Tax free municipal bonds are very similar to a Roth in that they are purchased with after-tax dollars and the proceeds are not taxed; they differ in being more predictable, generally paying a fixed interest rate, and in liquidity: while they are fairly easy to sell, you need to hold them to maturity or risk a penalty, whereas the principal deposited in a Roth can be withdrawn at any time.
Of course, you can combine various tax shelters, but the trick is to do so using investment vehicles that complement, rather than duplicate, each other's protection. For example, it wouldn't make sense to hold municipal bonds in a Roth IRA, because they both provide tax-free earnings; similarly, you wouldn't want to hold them in a 401(k) because all withdrawals from the 401(k) are taxed equally. In other words: before combining tax-advantaged investments, consult a qualified tax lawyer!