When saving for retirement, where you choose to put your money has an impact on the future taxes you’ll pay.
Chad Kennedy, partner and financial planner at Lighthouse Financial, said the goal of tax planning is to reduce the amount of taxes you pay throughout your entire life, rather than trying to reduce your tax burden in a single year.
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“By utilizing various types of investment accounts, you will be able to significantly reduce your tax burden across your entire lifetime,” he said. “There are three types of investment accounts: pre-tax, after-tax and tax-free accounts. Ideally, a person should seek to accumulate their assets in a balance across all the types. This ensures that you are benefiting from the tax advantages of each. Most importantly, it will give you control over how you are taxed in retirement.”
Here’s expert advice on how to mix your retirement accounts to avoid future taxes.
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What To Consider When Mixing Retirement Accounts
“When the goal is to reduce the tax burden, you want to focus on pre-tax contributions into an employer plan, whether it is a 401(k)/403(b)/457 or any other employer-based plan,” said Joseph Favorito, CFP and founder and managing partner of Landmark Wealth Management LLC.
“Contributions to these plans reduce your adjusted gross income (AGI), which not only lowers your tax liability but in some cases reduces the AGI enough to allow for additional contributions into other accounts such as a Roth IRA.”
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How To Combine Roth IRAs and Traditional IRAs To Maximize Tax Benefits
“The contribution to an IRA is a combined annual cap of $7,000 annually ($8,000 if over age 50),” Favorito said. “This can be divided up so that a portion can go in each. Whether or not you should use both or one versus the other depends on your tax status for that year.
“As an example, if you participate in an employer plan such as a 401(k), most of the time you will not be eligible for the tax deduction on the traditional IRA, which makes the Roth more attractive. It is case by case.”
How 401(k) Accounts Benefit a Tax-Efficient Retirement Strategy
“The 401(k) is vital in bringing down the AGI, which can then potentially allow a Roth contribution, as well as aid in other tax strategies,” Favorito explained. “The income limits to contributing to a Roth are based on your AGI.”
How Health Savings Accounts Can Be Utilized for Tax Reduction
Favorito said HSA accounts serve as hybrids between traditional IRAs and Roth IRAs, when used for medical expenses.
“The contributions are deductible, and the money comes out tax free,” he said. “However, if you don’t need the money for medical expenses, once you turn 59 ½, the accumulated dollars are treated as a traditional IRA for tax purposes. If not used for medical expenses, the withdrawals are taxable, but you still kept the deduction on the contributions by reducing your AGI each year you contributed.
“For those that are maxed out on their employer 401(k) plan, the HSA account can be an added savings. It works better if you can utilize those dollars towards medical expenses. However, it is still valuable as an added savings tool if you don’t need it for medical costs.”
Benefits of Incorporating Taxable Brokerage Accounts
“If you plan to retire early, then access to a traditional retirement plan can pose problems due to the rules around penalty-free withdrawals only after 59½,” Favorito said. “There are ways around this, such as the 72T withdrawal strategy. However, you will have restrictions.
“By saving a certain amount in taxable investment accounts, you can use them as a source of income to bridge the gap to penalty-free IRA/401(k) withdrawals. If you are efficient with managing a taxable brokerage account, you can minimize the tax liability over the years through proper tax loss harvesting techniques.”
How To Balance Contributions Between Tax-Deferred and Taxable Accounts
Favorito said balancing contributions between tax-deferred and taxable accounts very much depends on your current tax bracket and the need for liquidity.
“Taxable accounts pass through an estate at death more favorably with the step up in basis rules,” he explained. “However, tax-deferred accounts permit more wealth accumulation when you are younger.
“It’s wise to maximize an employer plan, especially if there is an employer matching contribution. However, when there are other goals in addition to retirement, such as buying a home or a car, it’s often wise to save independently of a tax-qualified account.”
Common Mistakes When Managing Multiple Retirement Accounts
Favorito said one common mistake is when you work more than one job or switch employers mid-year.
“This can lead to overcontributing due to the fact that the two payroll departments are unaware of how much was contributed at the other location,” he explained.
Favorito pointed out that another common mistake is in the investment allocation.
“By having many accounts scattered, you often end up with an investment allocation that is not a cohesive strategy,” he said. “It’s important to look at the totality of all of your investments, rather than looking at it on an account-by-account approach.”
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This article originally appeared on GOBankingRates.com: I’m a Financial Planner: Here’s How To Mix Your Retirement Accounts To Avoid Future Taxes
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