As you save for retirement today it is important to not only consider the tax benefits of putting the money away, but also to think about the tax rules that will apply when you spend the money in retirement. By striking a balance among different types of accounts with varying tax treatment, you maintain greater control over your tax liability in retirement.
Compare the two situations below:
- Jim, age 60, retires this year with $3 million in his 401(k) which is his only retirement savings account. He requires $78,000 of annual after-tax income to maintain his current lifestyle. In order to end up with $78,000 in after-tax income, he’ll need to pull $100,000 from his 401(k) and pay $22,000 in federal income taxes.
- Betty, age 60, also requires $78,000 in annual after-tax income, however, her $3 million is spread evenly among her 401(k), Roth IRA, and Mutual Funds. She will pull $30,000 from her 401(k) and pay $4,000 in taxes. She will pull $26,000 tax-free from her Roth IRA, and will pull $27,400 from her mutual fund portfolio and pay $1,400 in long-term capital gains taxes. As you can see, she has much greater control over her tax situation than Jim and her tax liability is $16,600 less than his. Granted, she gave up some tax benefits while saving for retirement, but her ability to limit her tax liability now, when she is on a fixed income, greatly outweighs the slight tax reduction she would have received by saving more in her 401(k) and less in her other accounts.
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