Deferring taxes with retirement savings is a key selling point for financial advisors. I mean, who doesn't want to save taxes? But, is deferring taxes for retirement savings always the best plan? That answer is not so simple.
Since we know that we are going to have pay taxes on our retirement savings at some point, the question is what is most tax efficient for you. The variables to consider are your current income tax rate, the anticipated tax rate when you retire, time until you will use the funds, and how long you will need the funds.
One of those variables sticks out like a sore thumb, anticipated tax rate when you retire. Who knows?! We have no idea what Congress will come up with next year, much less decades from now. What is probable, is that tax rates are not going to be lower than they are now, and that rates will be still graduated, meaning the more income you make the higher the rate.
When investing for retirement, you have two options, a traditional retirement account and a ROTH account. These accounts are available individual (e.g. IRA) and in 401k plans. While both share tax deferral of gains and income, the traditional account gives you a current tax deduction. The ROTH account gives you now current tax deduction.
For a traditional you receive a current deduction, and then you pay taxes when you withdraw. So if you have a current tax rate of 20% and you expect to have a 35% rate when you access the funds, the traditional account may not make sense for you. It is a function of time, and you will have to do a present value of cash flows calculation (or you can have us do it!) It is worth noting that ALL income that is distributed from a traditional account is ordinary income. Historically rates on ordinary income are higher than rates for capital gains. Much of your gains in your retirement savings will be from capital gains, so using a traditional retirement account removes this tax benefit.
A ROTH account receives no current tax deduction, but (under current law) the distributions are not taxable. An additional benefit of a ROTH account is that there are no minimum required distributions as required with a traditional account. This makes the ROTH an ideal way to pass on assets to your heirs.
Generally speaking, the younger you are, the better the ROTH calculations come out. But you need to do the calculations for you.
Consider real estate as a retirement investment. Yes, the current rental income is taxable, but any increase in value is deferred until you sell the property. If you use a 1031 exchange, you can invest in replacement real estate and defer the taxes indefinitely. Then (under current tax law) when you pass, your heirs receive a step up in basis to the current value, erasing ALL of the capital gains from appreciation!
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