Most people know they need to save for retirement but may not realize the importance of where to save. Taxes are not the most entertaining topic to talk about, but it could potentially save you thousands of dollars. Ideally, we want to diversify our money into multiple buckets to make sure we set ourselves up for success with taxes now and in the future. I’ll explain the parts of the tax triangle and how to use them to your advantage.
Tax Free Accounts are tax-free when withdrawn, so you don’t have to pay any tax on the growth. Contributions are made with after tax dollars. These are my favorite because the flexibility it provides you. There are restrictions on funding but if you’re eligible, it often makes sense to contribute if you think you’ll be in a higher tax bracket in the future. These accounts are:
- Roth IRA
- Roth 401(k)
- Health Savings Account
- 529 Plan/ Educational Savings Account
- Municipal Bonds
- Cash Value Life Insurance*
Tax-Deferred Account means you pay taxes when you withdraw your money. A positive is your money grows tax deferred and you can take a deduction the year of your contributions. The negative is Uncle Sam will be waiting for his portion and will require you to take distributions even if you don’t want to. Additionally, there are IRS restrictions on funding and withdrawals. The accounts that fall into this category:
- Traditional IRAs
- SIMPLE IRAs
- SEP IRAs
Taxable Accounts are taxed every year. Contributions are made with after tax dollars. I like to call these the “tax me always” account. Over time you will see the most frequent tax liability, as interest, dividends and short- and long-term capital gains are all taxed annually as recognized. The positive of these accounts is there are no restrictions on depositing and withdrawing money. Example of those accounts are:
- Money Market
Below you can see how tax rates have changed throughout history. Could tax rates go higher in the future? Potentially. Since we can’t know for sure, why not create a strategy to have more control of how much and when you pay taxes. By diversifying where you save your money, you may be able to keep more of it.
At some point in the future, you will need to use your money for an expense. It could be short term expense like a new car or a long-term living expense. How much you should be saving to what account depends on your specific situation and is something we can help you plan for today. The tax triangle gives you additional options and flexibility when it comes to tax and financial planning.
Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial does not provide research on individual equities. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. All investing involves risk including loss of principal. No strategy ensures success or protects against loss. This information is not intended to be a substitute for specific individualized tax advice. We suggest you discuss your specific tax issues with a qualified tax advisor.
*Not all cash value life insurance policies.
Tax rate over 50 years charts: Click here