Pay Taxes on Retirement Savings Now or Later
If you’re saving for retirement, you’ve probably wondered: Should I pay taxes now with a Roth account, or later with a traditional (pre-tax) account? But it doesn’t have to be an either-or choice. For many people, the best strategy involves combining both in a way that gives you greater flexibility down the road.
Why the “Now vs. Later” Debate Falls Short
Roth accounts require you to pay taxes up front, with the benefit of tax-free withdrawals in retirement. Traditional accounts, on the other hand, offer a tax break today in exchange for paying taxes later when you eventually take distributions.
The challenge is that no one knows for sure what future tax rates — or their personal financial situation — will look like years from now. Will your income be
higher or lower? Will tax laws change? Are there years when your income needs may be higher? Trying to determine the “better” option decades in advance can feel like a gamble with costly consequences. That’s why relying solely on one tax strategy isn’t always the best approach.
What Is Tax Diversification?
Tax diversification means spreading retirement savings across accounts that are taxed differently — some now, some later and some along the way — to create greater flexibility in retirement. Instead of putting all your eggs in one tax basket, you’re creating more options for yourself. And this allows you to decide where to draw income from during retirement based on your needs, and the tax environment, at that time. Just like diversifying investments can help manage market risk, tax diversification can help manage future tax uncertainty.
How Flexibility Can Work in Your Favor
Having both Roth and traditional savings can give you more control over your taxable income in retirement. For example, you might withdraw from a traditional account up to the top of a desired tax bracket, then supplement any additional income with tax-free Roth withdrawals to avoid being pushed into a higher bracket. You can choose where to withdraw from based on what makes the most sense for your situation year to year.
This can be especially helpful in a few key areas. For example, higher income can cause more of your Social Security benefits to be taxed, increase your Medicare premiums or cause capital gains to be taxed at higher rates. Larger balances in traditional, tax-deferred accounts can also lead to higher required minimum distributions (RMDs) later in retirement — potentially increasing taxable income whether you need the money or not. Roth accounts, on the other hand, don’t require RMDs during the original owner’s lifetime — a relatively recent rule change — which can provide additional flexibility in managing income.
Where to Begin
If you’re contributing to a workplace retirement plan, check whether you have both pre-tax and Roth contribution options available. If so, you could consider contributing to both types of accounts. The right mix will vary based on your income, tax outlook, financial plan, timeline and other factors. A conversation with a Financial Professional can help you determine the best approach for your situation and make sure your strategy aligns with your retirement goals.
Sources
https://www.kiplinger.com/taxes/tax-planning/tax-diversification-strategy-for-retirement-income
https://www.fidelity.com/viewpoints/retirement/tax-savvy-withdrawals
https://www.kiplinger.com/taxes/roth-401k-changes-what-you-should-know
https://www.ssa.gov/benefits/medicare/medicare-premiums.html
https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds