If you celebrate, I hope you had an enjoyable Easter
holiday. It was a nice day
weather-wise. I saw lots of pictures of children
going on egg hunts. Now that my own kids
are older, we don’t do that anymore, but I remember when they were younger
letting them run around the yard.
However, the fun activity of finding eggs and putting in a
basket is opposite of that saying I’m sure everyone knows…
Don’t put all of your eggs in one basket…
What does this have to do with tax and retirement advice?
Well, that saying is really about diversification. And I’m sure you’ve heard plenty of pundits
talk about the importance of diversification as it relates to your retirement
or investments. Put some in stocks, put
some in bonds, etc.
But rarely do people consider this: Have you diversified your retirement account
based on taxes?
If you listen to those pundits, many will tell you to
maximize the contributions to your traditional 401(k) or IRA accounts. And saving for retirement is certainly
important, but blindly following that advice is leaving a lot out.
Instead of stocks versus bonds, consider diversifying your
retirement accounts by taxable, tax deferred, and tax free.
Why is this important?
Well, nobody knows what income tax rates will be in the future. Having different accounts will allow you to
minimize taxes at a time when you will need the money to last as long as you do. Further, you will be able to pick which
account you withdraw from when you need the money.
The other aspect that most pundits don’t consider is the
issue of required minimum distributions, or RMDs. After a certain age, the IRS requires you to
withdraw money from traditional IRAs and 401(k)s whether you need the money or
not.
If you have to take out money you don’t necessarily need at
the moment, that extra money can cause your Social Security benefits to be
taxable and force you to pay higher Medicare premiums.
This table summarizes the different account types:
|
Tax
Treatment
|
Account
Type
|
Tax Impact of
|
RMD?
Yes/No
|
|
|
Contributions
|
Withdrawals
|
|||
|
Taxable
|
CDs, stocks, mutual funds
|
After tax
|
Principal tax free; gains may be
taxable
|
No
|
|
Tax
Deferred
|
IRA, 401(k)
|
Pre tax
|
Taxable
|
Yes
|
|
Tax Free
|
Roth IRA, Roth 401(k), Cash value of
life ins
|
After tax
|
Tax free
|
No
|
The general rule of thumb is that the younger you are, and
the more beneficial tax-free accounts are.
Why? Younger workers can pay a
low tax rate today in order to save a high tax rate tomorrow as their salaries
climb.
If you are older and more established, then tax-free
accounts may still be the better option because of those RMDs. After all, don’t you want to be able to
control your own money?
Don't follow the Easter bunny and put all of your eggs in one tax basket!
So the next time you hear that pundit say you should
diversify your portfolio, make sure you do COMPLETELY!
