Imagine you’ve managed to stash away a hefty X million dollars for your retirement. You’re all set for that long-awaited, sun-kissed retirement in the tropics you’ve been dreaming of for years. You might even consider taking an early retirement. Everything seems to be falling in place perfectly, right?
Not quite.
Remember that old adage from a well-known superhero movie that “with great wealth comes great taxes?” Well, it’s especially true when it comes to retirement savings. As soon as you start drawing from your retirement accounts, you’ll be hit with income taxes. And in some cases, substantial ones at that.
TAX-DEFERRED VS TAX-FREE
Tax-deferred retirement plans rank among the best investment options around. They allow even those with modest income to amass considerable wealth, thanks largely to their tax-deferred status.
Your contributions not only reduce your taxable income in the year they’re made, offering significant income tax cuts, but they also allow for the growth of investment earnings tax-free. You can enjoy several decades of unhindered growth, not reduced by income tax. This offers a viable path towards a high six-figure or even a seven-figure portfolio in less than a lifetime.
However, there’s a crucial distinction to make. Your retirement plans are tax-deferred, not tax-free. If they were tax-free, you wouldn’t have to worry about income taxes. But with tax-deferral, taxes remain an inevitable concern, possibly sprung at the least opportune time.
For instance, a sizable retirement portfolio inevitably means sizable distributions, especially once you reach the age of 70 ½ when required minimum distributions (RMD’s) come into play. An annual 4% “safe withdrawal rate” on a $2 million retirement portfolio could result in an income higher than the salary that funded the portfolio. Consequently, you might end up with higher income taxes than anticipated.
It’s wise to prepare for this scenario in advance, tweaking your strategy while there’s still time. This especially holds true if your retirement portfolio is projected to exceed a million dollars.
ROTH IRA: THE SAVIOR
A Roth IRA could serve as an excellent tax diversification strategy during your retirement. Although you can’t deduct your contributions in the years you make them, you can start withdrawing funds tax-free and without penalty once you reach 59 1/2.
If a significant portion of your retirement portfolio is in a Roth IRA, then a significant part of your income will be too. This tax-free income will be key in offsetting the taxable income you withdraw from more traditional retirement plans.
Furthermore, a Roth IRA holds an additional advantage when it concerns early retirement. If you retire at age 59 1/2, before you’re eligible for Social Security and/or pension benefits, a Roth IRA lets you withdraw money as needed without worrying about tax implications.
Maximizing Roth IRA contributions, which have increased from $5,000 in 2012 to $5,500 in 2013, offers a meaningful boost to your tax diversification. If you’re 50 or older, you can add an extra $1,000 as a “catch-up provision”, taking the total to $6,500. If you don’t already have a Roth IRA, start one to boost your tax-free income during retirement.
EXPLORING NON-TAX SHELTERED PLANS
There’s another strategy to help diversify your retirement taxes – non-tax sheltered investment accounts. These can include interest-bearing investments like certificates of deposit and treasury bills, broker accounts, managed funds or exchange-traded funds. Withdrawals from these accounts won’t be subject to any tax, as all taxes are paid while the accounts accrue. Though they may not grow as swiftly as tax-deferred accounts due to the annual income tax payments on earnings, they are worthwhile to have in addition to your retirement plans.
As a bonus, if you retire early, prior to 59 1/2, you can withdraw money tax-free. This could be a valuable resource to bridge the financial gap between early and traditional retirement at 65.
While it’s a common belief that individuals will be in a lower tax bracket post-retirement, those who’ve worked towards accumulating a large retirement portfolio might find this untrue. That’s why implementing retirement tax diversification in your portfolio as soon as possible is a smart move. Have you thought about the possibility that you might end up in a higher tax bracket upon retirement?
