Bruce Helmer and Peg Webb

Planning for retirement often falls to the bottom of the list of priorities, but it’s important not to put off the process. Planning today improves the odds that your savings and investments will help you maintain your desired lifestyle after you stop earning a regular paycheck.

Also, by planning early, you’ll also be able to handle the tax bill that likely will come each year after you retire.

Retirement planning boils down to addressing the key risk factors that impact retirement security: longevity (how long you’ll live), inflation (protecting the purchasing power of each dollar), public policy (changes in future tax rates), and a sustainable rate of withdrawal over time. The typical building blocks for retirement income include the following:

• Assets held in taxable brokerage accounts or bank savings accounts

• Guaranteed sources of income, such as Social Security or pensions

• Insurance benefits

• Savings and contributions to retirement-focused accounts, such as your 401(k), traditional IRA or Roth IRA

Good retirement income planning must go beyond simply joining your company-sponsored retirement plan or opening an IRA at your local bank. You also need to make sure a good portion of your future income is positioned for long-term growth and is as tax-efficient as possible.

There are three basic types of retirement accounts, based on how they are taxed: tax-deferred, tax-advantaged, and taxable. Learning the features of each is important because their different tax treatments can have a big impact on the ultimate size of your nest egg.

Tax-deferred accounts

Employer-sponsored 401(k)s are by far the most popular retirement account among for-profit businesses. Similar defined contribution plans are available for schools and university systems (403(b) plans), government entities (457 and 401(a) plans), and the federal government’s Thrift Savings Plan. Sole proprietors and other small businesses can use Solo 401(k)s, Simplified Employer Plans (SEP-IRA), or SIMPLE IRAs.

All defined contribution plans essentially work the same way:

• You invest pre-tax money into an account set up in your name, and you select investments from the plan’s available lineup.

• The employer may match a certain percentage of your salary as their contribution (say, 50 cents for every dollar you put in, up to 10% of your income).

• You reduce the amount of each year’s taxable income by the amount you put into your account.

• You pay no taxes on the accumulation in your account until you begin taking withdrawals. When you’re ready to withdraw funds in retirement, your withdrawals will be taxed as regular income.

• As with all tax-deferred retirement accounts, withdrawals made before reaching age 59½ are subject to a 10% federal income tax penalty.

• Required minimum distributions (RMDs) begin when you turn 73.

An Individual Retirement Account (IRA) is similar to a 401(k) but with some differences. Perhaps the most important is that the deductibility of your contributions depends on whether you (and/or your spouse, depending on how you file your taxes) also contribute to an employer 401(k) plan. Contribution limits and catch-up contributions are lower than with 401(k), and, of course, there’s no available employer match. IRAs generally offer a wide variety of investment options and, as with a 401(k), you pay no taxes on the accumulation in your account until you begin taking withdrawals. Withdrawals are taxed as regular income (plus a 10% federal penalty if taken before age 59½).

Tax-advantaged accounts

These accounts, such as Roth IRAs and Roth 401(k)s, move your tax liability from the future to the present. A Roth IRA can be owned by individuals or offered by employers through their 401(k) plans.

Contributions are made with after-tax dollars, meaning that you pay taxes on the funds you invest at the start, with no available tax deduction. Hopefully, your investments will grow over time, and you’ll pay no taxes on that accumulation or distribution.

However, the IRS rules around tax-free withdrawals can be a little tricky. For example, for withdrawals to be tax-free, the account needs to have been open for at least five years and you must be at least age 59½.

Still, tax-advantaged accounts can be great if you anticipate being in a higher tax bracket when you retire. They are also simple and efficient ways to pass wealth tax-free to your heirs.

Taxable accounts

To bridge the gap between tax-deferred and tax-advantaged accounts, many investors also hold assets in taxable accounts. Taxable accounts have none of the tax benefits we’ve just described, but they serve an important role in your tax diversification strategy. Taxable accounts typically include brokerage accounts, savings accounts, and other liquid accounts that allow you to invest and withdraw when you please.

Taxable accounts are subject to tax rules depending on the nature of the assets held within the accounts, such as long-term or short-term capital gains taxes. But they allow you to invest in taxable investment accounts without triggering an immediate taxable event. Instead, dividends and other distributions generated by your investments are taxable at year-end, and if you sell assets within these accounts, you’ll pay taxes on the gains (albeit at more favorable rates than ordinary income rates).

Thus, the three key advantages of taxable accounts are accessibility, in that you can withdraw funds at any time and any age without penalty, immediate liquidity in years leading up to retirement, and added flexibility for years after you retire.

Importance of tax diversification

While reducing today’s taxes is important, there’s a lot more to retirement tax strategy than simply reducing this year’s taxes. Diversifying your investments across all three types of retirement accounts is a critical element of lifetime tax efficiency.

Having too much of your nest egg in a 401(k) or IRA could put you at a disadvantage when you retire. That’s because you won’t get your entire balance as you spend it down: Up to a third or more of your income will be paid in state and federal income taxes.

The key question is to determine how much to move between your retirement accounts and when. And the answer to that question is directly tied to your needs and unique financial situation. We recommend working with an experienced and knowledgeable financial adviser to build a comprehensive financial plan based on a foundation of tax control, excellent asset management, and a commitment to understanding your unique needs.

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. 

Bruce Helmer and Peg Webb are financial advisers at Wealth Enhancement Group and co-hosts of “Your Money” on WCCO 830 AM on Sunday mornings. Email Bruce and Peg at yourmoney@wealthenhancement.com. Securities offered through LPL Financial, member FINRA/SIPC. Advisory services offered through Wealth Enhancement Advisory Services, LLC, a registered investment advisor. Wealth Enhancement Group and Wealth Enhancement Advisory Services are separate entities from LPL Financial.