(Forbes) Many people investing in retirement plans such as 401(k), 403(b) and IRAs don’t fully understand tax-deferred investing. Let’s look at a few of the tax issues related to retirement planning and investing.
Short-term tax vs. long-term tax aka capital gains
Let’s start by understanding how your money gets taxed if it is not in a tax-deferred account. Investments such as CDs that are held at a bank or brokerage firm are considered short-term investments. For example, say you invest in a 30-day CD for which you will receive $100 in interest.
It’s taxed as a short-term gain that will be taxed at your marginal tax rate which could be as high as 39.6%. You thus lose $39.60 to taxes. Let’s say instead your gain is considered a long-term gain and gets taxed at long-term capital gains rates, which could be as high as 20%.
You would gain almost $20 by simply having your $100 interest taxed as long term gains vs. short term gains.
Tax-deferred retirement planning
For retirement savings, you can use tax-deferred investments such as a 401(k) or an IRA. In this case, the government does not tax your savings when you deposit it nor are you immediately taxed on any gains that you make. Instead they allow the money to accumulate much faster and grow to be much larger because you are not paying taxes or capital gains on your investment. Well, not until you withdraw it! If you’re fortunate enough to be able to participate in a company sponsored retirement plan such as a 401(k) or 403(b), you have the ability to save up to $18,500 annually. If you are over 50, you’re allowed an additional $6,000 annually as a “catch up” contribution.
A traditional IRA only allows you to contribute $5,500, with an additional $1000 for the over 50 “catch-up” contribution.
Unlike the taxable account example (such as a CD) where you have the possibility of short or long-term gains, all of the future earnings, (including the savings in a 401K or IRA that never got taxed) will be taxed at your future income tax rate when withdrawn. For 401(k) or IRA accounts, you can withdraw money with no penalty starting at age 59½. You will pay taxes on the growth and the savings. Remember that the initial savings weren’t taxed. The income tax on tax deferred savings has to be paid sometime. For 401(k) and IRA accounts, you are required to begin distributions (spend money) at age 70½. That’s when the government says it’s been long enough, you haven’t paid taxes on this money and we need to get some revenue back into our coffers.
You may be aware that there is a penalty of 10% if you choose to take the money out of your 401(k) and IRA before you are 59½. I call that a slap on the hand for taking money out of the cookie jar early. Congress is essentially saying we gave you this tax-deferred benefit for your retirement and had we known that you were going to choose not to use it for retirement, we would’ve taxed you differently. You would’ve been taxed at either the short-term or long-term gains rate discussed earlier.
A Roth IRA or Roth 401(k) varies from the IRA and 401(k) in that your contribution is taxed today. That is, your contribution dollars are post-tax as opposed to pre-tax like 401(k) or IRA contributions. Like the 401(k) and IRA, your investments earnings are not taxed and neither are your withdrawals.
Roth IRAs and Roth 401(k)s allow you to withdraw your money without tax or penalty starting at 59½. However, unlike the 401(k) and Traditional IRA, you don’t pay taxes on the gains. Remember that you paid taxes on your original savings when it was deposited into the Roth account. That means when you withdraw a dollar, you get a dollar. While there are penalties for use before age 59 ½, if you don’t pull more out than what you have saved, they don’t kick in.
There are different investing strategies depending on whether or not you will be taking money out as taxable or tax-deferred. There are certain investments that generate more gains than others. For example, if you trade frequently, that would generate lots of short-term gains in your account.
If you’re not being taxed, then you might choose investment strategies where there is more frequent trading.
Frequent trading would increase taxes at the higher short-term marginal tax rate. There are investment managers that you use who will adjust the way they manage your account based on whether it’s a taxable or tax-deferred account.
What tax-deferred can do for you
I have only briefly touched on the differences in taxes based on the tax environment in which the investment is held. What you can see is that taxes can take a large chunk out of whatever you make. The penalties for spending money in tax-deferred accounts before age 59½ can be devastating.
It’s important in your financial planning that you consider taxes as part of your investing strategy. If you believe you’re going to retire earlier than age 59½, you want to have adequate savings in non- tax-deferred accounts that won’t get hit with the 10% early withdrawal penalty. It’s important that you work with a CFP professional and/or Certified Public Accountant familiar with retirement tax planning. Why not get a financial review to see if you can get your taxes to do more for your retirement money?