Don’t put all your retirement savings in a 401(k), says CFP

  • A 401(k) is a great retirement savings account, but it shouldn’t be the only one you choose.
  • Contribute up to your employer’s match, then put money into a Roth account and a taxable account.
  • Tax diversification in retirement will protect you from changes in tax laws and keep money flowing.

Retirement is an important financial goal, and there are many ways to achieve it. A common path is through a 401(k), a pre-tax retirement plan offered by many employers. As a financial planner, I’m a big fan of these plans — they encourage automatic contributions and sometimes come with an employer match. But, I also believe that you shouldn’t put all your savings in one basket.

You may have heard of the power of diversification when it comes to choosing your investments. Investing in too much of one thing can expose you to more risk and make you vulnerable to market fluctuations. But did you know you should also diversify or are you investing? When it comes to saving for retirement, I believe tax diversification is just as important as portfolio diversification.

Taxes affect how much money you can keep in retirement, and tax diversification is one strategy to make your money last. Your retirement accounts contain tax-deferred, taxable or non-taxable funds. Creating a strategy that takes into account the various tax treatments of your accounts can help you save money and give you more flexibility in how you access your savings.

Choose before- and after-tax retirement accounts

Pension plans are made up of pre- or post-tax contributions (or a mix of both). Pre-tax contributions, typically found in your standard 401(k), reduce your income taxes during your pre-retirement years, while after-tax contributions, typically found in Roth IRAs and Roth 401(k), help reduce your tax burden. retired. You can also save for your retirement in traditional investment accounts, which are often after-tax contributions.

Pre-tax contributions allow you to defer paying taxes on contributions and earnings. For example, if you contribute to your company’s 401(k), any money you add to it and any growth on your investments will not be taxed as long as the money remains in your account. When you retire, you will pay taxes, but you may be taxed at a lower rate because your taxable income and

tax bracket

is less than your working years.

After-tax contributions provide tax-free income during your golden years and can reduce your overall tax burden in retirement.

The benefits of tax diversification in retirement

Investing in before and after tax retirement accounts gives you the best of both worlds. Having a balance between these two different tax streams provides more flexibility and sustainability for your savings and makes your accounts more resilient to future tax law changes.

Tax diversification helps bring order to how you should make your retirement withdrawals, helping you structure your withdrawals to maximize your after-tax income. Generally, once you reach retirement age, you will begin to take the required minimum distributions from your accounts. To get the greatest benefit, you will take the distributions from the tax-deferred accounts and then the distributions from the tax-free accounts. Of course, it is important to consult your personal financial adviser or tax specialist for a specific tax reduction plan.

The 3 accounts to consider

So where should you invest? I recommend a combination of a few different accounts. My rule of thumb is to invest in your 401(k) first, if your company offers one. Make sure you contribute at least up to your employer’s annual maximum, otherwise you’re just leaving money on the table. If you have extra funds available, consider investing in an after-tax account like a Roth IRA or a Roth 401(k) next. Keep in mind that there is an income eligibility requirement for Roth IRAs. Finally, consider a taxable brokerage account for the rest of your savings.

What makes this strategy a winner? All withdrawals from your pre-tax retirement accounts are taxed as ordinary income, while all withdrawals from your taxable accounts (from the sale of stocks or mutual funds) may be taxed at

capital gains

rate, depending on your income and how long you have held the investment. All withdrawals from your after-tax retirement accounts are fully tax-free. In other words, like the benefits of portfolio diversification, tax diversification reduces your overall risk from changes in tax laws or other policy changes.

Overall, the goal of retirement is to enjoy yourself after years of hard work. The last thing you want is to worry about taxes or end up with less than you thought you had after Uncle Sam took his cut. Tax diversification will help reduce this risk (and worry) for your future.


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