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Courtesy Hanna Horvath
Retirement is an important financial goal, and there are many different ways to get there. A common path is via a 401(k), a pre-tax retirement plan offered by many employers. As a financial planner, I'm a big fan of these plans — they encourage automatic contributions and sometimes come with employer matching. But I also believe you shouldn't put your whole nest egg in one basket.
Maybe you've heard about the power of diversification when it comes to choosing your investments — investing in too much of one thing can open you up to more risk and make you susceptible to market swings. But did you know you should also diversify where you invest? When it comes to retirement savings, I believe tax diversification is just as important as portfolio diversification.
Taxes affect how much money you get to keep in retirement, and tax diversification is a strategy to help your money last. Your retirement accounts contain either tax-deferred, taxable, or tax-free funds. Creating a strategy that accounts for the various tax treatments of your accounts can help you save money and give you more flexibility in how you access your savings.
Retirement plans are made of either pre-tax or post-tax contributions (or a mix of both). Pre-tax contributions, typically found in your standard 401(k), reduce your income taxes during your pre-retirement years, while after-tax contributions, typically found in Roth IRA and Roth 401(k) accounts, help reduce your tax burden in retirement. You can also save for retirement in traditional investing accounts, which are often after-tax contributions.
Pre-tax contributions allow you to delay paying taxes on contributions and earnings. For example, if you contribute to your company's 401(k), any money you add to it and any growth in your investments won't be taxed as long as the money stays in your account. When you retire, you'll pay taxes, but there's a chance you'll be taxed at a lower rate because your taxable income and tax bracket are lower than in your working years.
Post-tax contributions provide tax-free income in your golden years and can reduce your overall tax burden in retirement.
Investing in both pre- and post-tax retirement accounts gives you the best of both worlds. Balancing these two different tax streams offers more flexibility and sustainability for your savings and makes your accounts more resilient against future tax law changes.
Having tax diversification helps provide some order in how you should take withdrawals in retirement, helping you structure your withdrawals to maximize your after-tax income. Typically, once you reach retirement age, you'll begin taking the required minimum distributions from your accounts. To get the biggest benefit, you'll take distributions from tax-deferred accounts and then distributions from tax-free accounts. Of course, it's important to consult your personal financial advisor or tax professional to get a specific tax-minimizing plan.
So, where should you be investing? I recommend a combination of a few different accounts.
My rule of thumb is to invest first in your 401(k), if your company offers one. Make sure you're at least contributing up to your employer's annual maximum match, otherwise you're just leaving money on the table. If you have extra funds available, consider investing next in an after-tax account like a Roth IRA or Roth 401(k). Keep in mind there is an income eligibility requirement for Roth IRAs. Lastly, consider a taxable brokerage account for the rest of your nest egg savings.
What makes this strategy a winner? All withdrawals from your pre-tax retirement accounts are taxed as ordinary income. In contrast, all withdrawals from your taxable accounts (from the sale of stocks or mutual funds) may be taxed at capital gains rates, depending on your income and how long you held the investment. Any withdrawals from your post-tax retirement accounts are completely tax-free. In other words — like the benefits of portfolio diversification, tax diversification reduces your overall risk from tax law changes or other policy changes.
The goal of retirement is to enjoy yourself after years of work. The last thing you want is to be dealing with taxes or finding yourself with less than you thought you'd have after Uncle Sam takes his cut. Tax diversification will help reduce this risk (and worry) for your future.
This article was originally published in April 2022.
