Tax planning is an essential part of managing your investments and saving for retirement. How taxes are applied to various investment accounts can make a considerable difference in your long-term return. Where you hold your assets can have nearly as large of an impact on performance as what securities you choose to invest in. Investors typically use investment accounts that fall into one of these categories:
1. Taxable accounts (such as a brokerage account or bank account)
2. Tax-deferred accounts (like a 401(k), traditional IRA or 403(b))
3. Tax-free accounts (like a Roth 401(k) or Roth IRA)
Taxable accounts include your typical brokerage accounts that you open by yourself or with the help of an investment professional, titled in your own name (or jointly with someone else). You invest after-tax dollars and pay taxes now on any investment income produced or capital gains incurred from buying or selling assets within the account.
Traditional 401(k)s and traditional IRAs tend to get the most attention when talking about tax-deferred accounts. The accounts allow you to invest pre-tax dollars, but future withdrawals from the account are taxed at ordinary income tax rates. For example, say your taxable income for the year is $55,000 and you contribute $5,000 to a tax-deferred account—you would only pay taxes on $50,000. Fast forward 30 years and you withdraw the $5,000 from your account—you will owe taxes on the $5,000 plus any growth. In other words, taxes are “deferred” until a later date and will be paid someday down the road.
Finally, tax-free accounts include the popular Roth 401(k) and Roth IRA. These accounts allow the owner to invest after-tax dollars and then withdraw funds tax-free after age 59½. Going back to the above example, you would be taxed on your total taxable income of $55,000 after investing $5,000 in a Roth account, but you would owe no taxes on the withdrawal of the $5,000 (along with any growth) in the future.
The ability to optimize your tax savings with the use of these varying account types depends on your current financial situation. Most young people who are just beginning to work and may be on the lower end of their lifetime earnings spectrum ought to focus on contributing to tax-free accounts, since they can pay the taxes at a lower tax rate today. It is likely that their tax rate will be higher in retirement. Conversely, high income earners should take advantage of the tax savings of tax-deferred accounts and delay paying taxes until they begin withdrawals later in retirement, when they may fall into a lower tax bracket.
Tax diversification can be just as important as investment diversification. Owning a combination of all three account types can give you some freedom to decide when you will pay taxes (except on tax-deferred accounts, which start required minimum distributions at age 70½—but that’s a different topic). It also allows you the opportunity to smooth income from one year to the next by giving you the option to withdraw from tax-free accounts during high-income years, and tax-deferred or taxable accounts during low-income years, helping you to “fill up” your tax bracket. Income smoothing can help you save considerable dollars on your tax bill during your lifetime.