No one likes to pay more in taxes than they have to, especially after working a lifetime to save for retirement. That’s why it’s important to not only consider diversification across asset classes, but also to consider tax diversification.
There are three categories for taxes and investments: taxable, tax-deferred, and tax-free.
- A taxable account might include stocks, bonds, or mutual funds that you purchase outside a retirement plan (a nonqualified account); you can be taxed on income received as the account grows, as well as on any profits made once the investments are sold.
- Tax-deferred, also known as qualified accounts, include 401(k), SEP, or SIMPLE accounts and grow tax-free in their savings years, but withdrawals are taxed.
- Tax-free accounts, such as Roth IRAs, are funded with after-tax dollars, grow tax-free, and distributions are typically tax-free for retirement-age individuals. Unlike traditional IRAs, they have no required minimum distribution. Younger individuals can take distributions in certain situations without penalty.
Having too much of your nest egg in the tax-deferred basket, such as a work-sponsored 401(k) and a traditional IRA, may increase your tax burden in retirement. To maximize the amount of money you get to keep vs. what you owe Uncle Sam, consider spreading your retirement nest egg across a variety of tax treatments.
Taxes Now vs. Taxes Later
Roth IRAs give investors the option to pay taxes now, when contributing to the account, rather than paying later when taking withdrawals. However, Roth IRAs have income-eligibility restrictions as well as lower contribution limits. If your income is too high, you’re unable to contribute directly.