Long-term investing has tremendous rewards for diligent savers. You can contribute to tax-advantaged accounts little by little through your working years, then come out looking like a hero on retirement day. It’s a process that happens over time, not overnight. Just like how you have to experience all sorts of market rises & falls and major changes in your life.
Taxes are tough to avoid, but we can actually do it! By contributing to the right mix of retirement and savings accounts at the right time, you can practice good tax avoidance techniques. Remember: tax avoidance is a good thing and should be practiced by all investors. Tax evasion, on the other hand, is illegal!!
Some of the solid choices for building long-term wealth include your 401(k), a Traditional Individual Retirement Account (IRA), Roth IRA, and a Health Savings Account (HSA). You have other account types for other goals, too. For college savings, a 529 educational investing account is a great choice and life insurance is used for estate planning & generational wealth transfers. Even a taxable savings & investment account has its place, too. We will leave those for another day.
Let’s talk about how each retirement account is taxed. It will give you a better idea of how each may be used throughout your lifetime. We know the ins & outs of all of these accounts, so by working with TFC, we can ensure you have the optimal strategy. The goal is to see these accounts swell in value so you can reach your financial goals quicker.
401(k)
Contributions through your employer are done ‘pre-tax’. That means there is no tax withholding and no current-year tax liability. The account grows tax-deferred, and then your withdrawals are taxed at ordinary income tax rates once you turn 59 ½ years old.
Sometimes it’s easier to put numbers to that; for example, if you contribute $10,000 to your 401(k) this year, and your marginal tax rate is 24%, then your current-year tax savings is $2,400 since you are avoiding taking that $10,000 as income today. Instead, you are putting it directly into the 401(k) account.
Let’s assume it grows at 7% per year for the next 30 years. The account will be worth $76,000 30 years from today. You don’t pay taxes as it grows, only when you withdraw it after age 59 ½ – at which time it is treated as ordinary income.
What’s neat is you have the option of when to withdraw it from your 401(k). Many retirees prefer to keep their income in the 12% marginal tax bracket or lower in retirement. If you do that, then you’ve essentially avoided paying tax at a 24% rate during your working years, and elected to pay tax at a marginal rate of 12%. And actually, your average tax rate in retirement may be under 10% due to the graduated tax bracket structure.
Traditional IRA
To spare you from redundancy, a Traditional IRA works the same way as a 401(k) in retirement.
One quick note – we recommend you rollover your old 401(k) into a Rollover IRA when the time comes. This just helps consolidate accounts and can save on fees. It also allows for better investment options. Just a little PSA from us at TFC!
Roth IRA
A Roth IRA works the opposite of a 401(k) and Traditional IRA. Here, you contribute money that has already been taxed, then the account grows tax-free forever. In retirement, you can withdraw with no tax liability. It doesn’t get any easier than that.
A Roth IRA is great for people just starting their careers or those who just have a year with low income. So you want to take advantage of paying the low tax rate today.
Health Savings Account
By now, you may be aware that we are advocates of using an HSA as a retirement savings vehicle if possible. What’s great is you get the current-year tax deduction as you do in your 401(k), then the account grows tax-deferred (again, like a 401(k)), but the great aspect of an HSA is that if you wait until you are 65, then you can withdraw from the account for ANY reason without penalty. Of course, most of us will have health expenditures along the way, and it’s fine to use the HSA to pay those medical bills. But if you can, just save your health care receipts, and ‘reimburse’ yourself from your HSA when you are very old. That way, you allow the HSA to compound.
To be clear, withdrawals from your HSA for qualified health expenses are always tax-free. Withdrawals before age 65 for non-health-qualified items face income tax and a 20% penalty – ouch! Withdrawals at age 65 or older for any reason other than health care do not face a penalty but are taxed as income (just like a 401(k) withdrawal).
For us in the Wolverine State, Michigan will levy a state income tax on some individuals. If you were born after 1952, then you will pay 4.25% tax on pre-tax accounts like a 401(k) and Traditional IRA. For those born before 1945, an individual can make up to $51,570 before you incur taxes. Those born between 1946 and 1952 have just a $20,000 income limit to avoid state tax.
Here’s the point
- Your 401(k) and Traditional IRA are great for use during your peak earning years so you can avoid paying taxes today. Those accounts are taxed at ordinary income tax rates during retirement.
- A Roth IRA is the opposite – you pay tax today and the account then grows tax-free forever. Great for those just starting out.
- 59 ½ is the key age for avoiding a 10% early withdrawal penalty from a 401(k) and IRA.
- An HSA can be used as a retirement vehicle – it has the ‘triple tax advantage’ if withdrawals are for qualified health expenses. If you want until age 65, then you can tap the account without penalty like you would for an IRA. Pro tip: keep your receipts and ‘reimburse’ yourself decades from now to allow your HSA to really grow.
Action items
- Are you in your peak earning years? Say in your 30s, 40s, or 50s? Then a regular 401(k) and Traditional IRA could be great options to reduce your current-year tax bill.
- If you are in your 20s or perhaps working fewer hours as you near retirement, a Roth IRA could be ideal so that you take advantage of being in a lower tax bracket.
- There’s a lot to consider here! Sit down with us at TFC to discuss your situation and goals. We can develop the right game plan for you.
Image by Nattanan Kanchanaprat from Pixabay