Many people investing in retirement plans such as 401(k)s, 403(b)s and IRAs don’t fully understand tax-deferred investing. This article highlights a few of the tax issues related to retirement planning and investing.
Short-Term vs. Long-Term Capital Gains Tax
Let’s start with how your money gets taxed if it is not in a tax-deferred account. Investments held at a bank or brokerage firm, like a CD, are considered short-term investments. For example, you invest in a 30-day CD for which you will receive $100 in interest. It’s taxed as short-term gains and will be taxed at your marginal tax rate, which could be as high as 39.6%. You will lose $39.60 to taxes. Let’s say instead your gain is considered long-term, it would be taxed at long-term capital gains rates which could be as high as 20%. You would gain almost $20 by simply switching from short- to long-term gains.
Tax-Deferred Retirement Planning
For retirement savings you can use tax-deferred investments such as a 401(k) or an IRA. The hybrid Roth will be discussed later. In this case the government does not tax you today on any gains you make, instead they allow the accumulation to grow to be much larger over time. For example:
If you’re fortunate enough to be able to participate in a company-sponsored retirement plan such as a 401(k) or 403(b), you control the ability to save up to $17,500 (or if you’re over 50, $22,000 or $23,000). The IRA only allows $5,500 (or $6,500 if you’re over 50) in tax-deferred savings. With a Roth IRA, while you are taxed today, the earnings you make on your investments are not taxed. Unlike our example in a taxable account where you have the possibility of short or long-term gains, all of the future earnings and the principle in an IRA that never got taxed will be taxed at your future tax rate starting at age 59.5 should you choose to make a distribution or take money out before age 70.5. That’s when the government says you haven’t paid taxes for long enough and we need to get some revenue back into our coffers. (For more from this author, see: Closing Your Retirement Income Gap With a 403(b).)
You may be aware there is a penalty of 10% if you choose to take money out before you're 59.5. I call that a slap on the hand for taking money out of the cookie jar early. It’s essentially saying we gave you this tax-deferred benefit for your retirement. If you choose not to use it for retirement we'll tax you differently, either at the short-term or long-term gains rate discussed earlier.
There are different investing strategies depending on whether or not you will be taking money out as taxable or tax-deferred. There are certain investments that generate more gains than others. For example, if you trade frequently that will generate lots of short-term gains in your account. If you’re not being taxed then you might choose investment strategies where there is more frequent trading. Frequent trading would increase taxes at the higher short-term marginal tax rate. There are investment managers you can go to who will adjust the way they manage your account based on whether or not it’s a taxable or tax-deferred account. (For related reading, see: Minimize Taxes With Asset Location.)
What Tax-Deferred Investments Can Do for You
I have briefly touched on the differences in taxes based on the tax environment where the investment is held. What you can see is taxes can take a large chunk out of whatever you make. The penalties for spending money in tax-deferred accounts before age 59.5 is even more devastating. It’s important in your financial planning that you match your investing based on tax strategy, tax-deferred or long-term gains, to your timeline. If you believe you’re going to retire earlier than age 59.5 you would want some non-tax qualified savings (retirement tax-deferred) that won’t get hit with the 10% early withdrawal penalty. It’s important that you work with a certified financial planner and/or certified public accountant familiar with retirement tax planning.
(For more from this author, see: Stay the Course With an Investment Policy Statement.)
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.