The following is adapted from Keep It Simple, Make It Big.
I’ve yet to meet someone who truly enjoys paying taxes. Even if you appreciate all that your taxes help to pay for in our country, you still probably don’t like paying your taxes for the simple reason that it’s so confusing.
This is especially true for retirement investments. There are many different types of retirement investments, and each one seems to have its own complicated tax rules.
If you’re not careful, you could be hit with an unexpected tax bill, or you might end up paying more than you need to.
To make sure you don’t get blindsided or end up overpaying, you need to understand how your various investments are taxed. To help simplify things, there are five major tax buckets you should know.
Bucket #1: Tax Me as I Go
These are often called after-tax investments. Professionals will also refer to them as “non-qualified” accounts. Income generated from investments in these accounts will be taxed as ordinary income in the year in which it’s generated.
Any dividends generated will be taxed as well, and growth is taxed as capital gains when the investment is sold and the gain realized. Capital gains and dividends are taxed at lower rates than income. (For those in the 12 percent federal tax bracket or lower, the rate is zero). Also, losses can be used to offset gains and even ordinary income in future years.
These accounts are typically bank savings, money market, CDs, mutual fund accounts, and stocks and bonds held in a brokerage account. You face no access restrictions on using these accounts.
Bucket #2: Tax Me Later
These accounts tend to be a person’s favorite while working. The reason: Contributions are pre-tax—they lower your taxable income dollar for dollar—and growth is tax deferred. They produce fewer smiles in retirement, however, as each dollar withdrawn is taxed as ordinary income at the person’s highest tax rate, even the growth attributable to capital gains.
These are our retirement accounts, the 401(k), 403(b), and 457 plans and traditional IRA.
They come with many access restrictions.
A 10 percent penalty is imposed if money is accessed before age 59½, for example. Exceptions include disability, a first-time home purchase, qualified education expenses, birth and adoption expenses up to a limit, separation of service for 457 plans, separation of service and age 55 for 401(k) and 403(b) plans, and systematic withdrawals at age 55 for IRAs. Most recently, the penalty was removed temporarily as a response to the COVID-19 virus.
At age 72, mandatory minimum distributions commence. Account holders must start taking out income and paying taxes whether they want to or not. The amount is based on life expectancy.
Bucket #3: Tax Me Never Again
In this bucket, contributions are made post-tax. The growth is not taxed, and the gains, if accessed correctly, will also not be taxed.
These are Roth IRAs and Roth 401(k)s, 529 plans, cash value life insurance, and municipal bonds.
These accounts come with far fewer restrictions than their pre-tax kin but still have some limitations.
Roth IRAs have contribution levels tied to income limits, and if you withdraw gains before age 59½, there is a 10 percent penalty, plus income taxes will be due (with some important exceptions for first-time home purchases, medical expenses, and education expenses). You can, however, withdraw your contributions (the money you put in, not the growth) tax- and penalty-free at any time for any reason at any age.
Section 529 plans are education savings vehicles. Their monies must be spent on qualified education expenses, otherwise penalties and taxes will apply.
The restrictions on cash value life insurance depend on the insurance company. If the policy is completely surrendered to access cash, ordinary income taxes will apply on the gains in the contract. Also, withdrawals may cause policy to lapse, at which point withdrawals greater than contributions will be subject to income tax. Life insurance must be carefully managed.
Bucket #4: Tax Me Later, but Only on the Gains
In this bucket, investments are made with after-tax dollars, and the growth of the investments occurs on a tax-deferred basis. When the money is withdrawn and spent, gains or growth will be taxed as ordinary income.
This tax characteristic applies to after-tax contributions to 401(k)s, non-deductible IRAs, and fixed- and variable-deferred annuities. The key is that there is no upfront tax break, but all growth is sheltered from tax until it’s withdrawn.
There are many complicating restrictions. If money is accessed before age 59½, a 10 percent penalty will apply to gains on both annuities and IRAs. For annuities, gains come out first, the opposite of Roth IRAs. There are no contribution limits on annuities, but IRA contributions are limited to current IRS limits.
Bucket #5: Tax Me Never Ever
This is the triple tax-free bucket. Like Bucket #2, contributions are made pre-tax. Even better, they avoid FICA taxation if made through payroll. Then, like Buckets #2 and #3, the investments grow on a tax-deferred basis. Finally, like Bucket #3, the money comes out completely tax free if the rules are followed.
At present, the only legal option for such wonderful treatment is a Health Savings Account (HSA).
As you can imagine, there are plenty of catches and restrictions to get no-taxation. To contribute to these accounts, one must have a qualifying high-deductible health plan with a minimum deductible of $1,350 for an individual or $2,700 for a family plan.
Contributions to the account are limited by the IRS. Limits in 2020 are $3,550 for an individual and $7,100 for those with a family plan. If you are 55 or over, you can add another $1,000. These funds can be invested in mutual funds and other securities.
Withdrawals are tax free if used for qualifying health expenses per IRS publication 502. The list is quite expansive and includes Medicare Part B and supplemental premiums in retirement. Withdrawal does not have to occur in the same year as the expense. Once on Medicare, people can no longer contribute to HSAs. They can still use the accounts—they just can’t put any new money in.
Which Buckets to Use
Most retirement investment strategies will make use of several of these buckets.
Obviously, Bucket #5 is the best, since you’re never taxed, but because you can only use this money on healthcare costs, you’ll need to use other buckets as well.
Bucket #1 is good for money that you want easy access to, since there are no restrictions on when or how you can use the money.
Bucket #2 is a good option for lowering your taxes now, and it’s especially smart if you think you’ll be in a lower tax bracket later in life.
In contrast, Bucket #3 is a good move if you’re currently in a lower tax bracket and expect to be in a higher one when you retire.
Bucket #4 usually isn’t people’s first choice, but it can be helpful if you want to save more than current limits on your other accounts, like a Roth IRA, allow.
Which buckets you choose will ultimately depend on your particular situation, but by understanding the various taxation methods, you can make a more informed decision.
For more advice on taxes on retirement investments, you can find Keep It Simple, Make It Big on Amazon.
Michael Lynch is a Certified Financial Planner with nearly twenty years of experience working with American families to craft plans that fund their dreams, educate their children, and finance their retirement. Michael has contributed to the Wall Street Journal and Investor’s Business Daily, and hosted Smart Money Radio for a decade. He’s served as an adjunct faculty member at Fairfield University and currently teaches financial planning to employees of corporations like Madison Square Garden and Yale New Haven Health Systems. Michael is a five-time Financial Planner of the Year for MetLife and a 2019 inductee to the Barnum Financial Group Hall of Fame. You can enjoy his latest articles and videos at www.michaelwlynch.com.
Representatives do not provide tax and/or legal advice. Any discussion of taxes is for general informational purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate. Michael Lynch is a registered representative of and offers securities and investment advisory services through MML Investors Services, LLC. Member SIPC. www.SIPC.org 6 Corporate Drive, Shelton CT 06484 CRN202210-272644