Taxes can play a huge role in the efficiency of your retirement savings. The tax type of an account or investment can vary and potentially impact your overall retirement savings dramatically. Before you decide to allocate money to a particular investment, it’s important to understand how taxes can impact the return on the investment.
For example, let’s say you have a currently taxable investment that yielded an 8% return. If you are in the 24% federal income tax bracket, your after-tax return on the investment would be only 6.08%. Now if you had the same 8% return but this time in a tax-deferred account you wouldn’t owe any federal income tax allowing the full 8% to be reinvested. This results in compounding returns each year. For this reason, it is important to have accounts with different tax treatments. Let’s dive into the different account types.
First you have currently taxable accounts which will include investments for which you generally receive a 1099. These investments include CDs, bond interest, stock dividends, and capital gains for stocks or mutual funds sold within the year.
Next, we have the tax-deferred accounts which are commonly known as tax qualified accounts. These accounts allow you to delay paying taxes until some point in the future, usually retirement. Many employer provided retirement plans fall into this category. Traditional IRAs, 401(k), 403(b), 457(b), non-qualified annuities, and savings bonds are examples of tax deferred accounts.
Next, we have income tax free accounts in which you use after-tax dollars to make contributions and provided you have met all the requirements, withdrawals will be tax free. A Roth IRA is an example of a tax-free account in which the earnings will be tax free when withdrawn. Life insurance proceeds are also tax free. Municipal bonds offer interest that is free of federal income tax and if issued in your state of residence, will also be state income tax free.
The allocation of each type of account will depend on an individual’s personal financial situation, their current and expected future tax rates. However, in general it makes sense to start moving funds from taxable to tax deferred to tax-free as you approach retirement. Working with a financial advisor to help you determine the right allocation between the different account types each year is an important step in your financial planning process.