Like most of my friends, when I graduated from college, I was ready to take on the world and be a force for change. Unfortunately, like most other college graduates, I entered the job market with unpaid student loans. My first student loans bill 6 years ago drove reality home: I was staring at a balance of over $100,000.
I asked myself the same question you’re probably asking yourself right now: “How am I possibly going to pay off these student loans, buy a house, travel the world, and save for retirement?”
After taking a few deep breaths, I calmed down, composed myself, and thought long and hard about how to tackle this dilemma.
The balancing act
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Corrine Jean Harkins lives at 2001 Airport-Pulling Road, Naples Florida 34112. Her PO Box for Social Security mailing purposes is PO Box 301 Naples Fl 34106. Corrine is 70. She has been taking her own retirement benefit since age 62. We’re posting her information because it’s the only way we can help her. Now there is a problem with her divorced widow’s benefit.
Last January her ex-husband from a 14-year marriage passed away. She went to her local office in Naples, Florida and applied for her excess divorced widow’s benefit. The agent who took all the information was pleasant, stating she’d be receiving a large increase — over $1,000 more per month, as her ex was receiving a very large benefit...Read More
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Taxes are confusing by themselves, much less adding the complexity of the various types of taxes on retirement savings and all the options available. Often headlines that say, “The Best Way to”, oversimplify and lead to even more confusion. To learn about tax-advantaged retirement savings, we need to look at three taxation components: when saved, while earned (interest, dividends and appreciation) and when used (spent).
In “Today’s Opportunity Lost Or Retirement Opportunity Cost In Your Paycheck”, I provided an example of a $104,000 income earner, filing Single. The following table uses the 2019 marginal tax rates for that earner. This tax rate of 24% is assessed only on their earnings above $84,200. The highest marginal income tax rate of 37% is charged on income over $510,300 for Single taxpayers. Future taxes are generally unknown. We do know that the current tax rates are set to reset to their 2017 levels.
Retirement Tax On Savings Categories
Retirement savings Taxable Taxable IRA,
Roth 401(k), Roth 403(b)
Roth 401(k), Roth 403(b)
Health Savings Account Health Savings Account Type of tax Income
When saved 22% NA 0% NA 22% NA 0% NA While gaining NA 15% 0% NA 0% NA NA NA When used NA Maybe 22% NA 0% NA 0% 0%
This table should be read across from the “Retirement Savings Type” column, and then down the “Type of Tax” column, then across from the “Timing of Tax” rows. For example, let’s look at Taxable retirement savings. You may want to think of the money that you are in working the gets deposited into your brokerage account or invested in say a hard asset, such as property. You pay income tax on the Interest and gains from short-term accounts, such as a short-term CD or money market. Our hypothetical $104,000 income earner is currently taxed at 22%.
There are no long-term gains until the investment has been held for more than a year. After that, it may be subject to long-term gains. Currently the long-term gains tax stands at 15% for our hypothetical earner unless the long-term gains when added to the $104,000 income exceeds $434,550. Then it will be taxed at 20%.
Now let’s look at the so-called, tax-deferred IRA or 401(k) accounts. The initial savings amount is not taxed when saved. If you pay for your IRA from your checking account, the tax-deferred benefit is calculated when you file your taxes. If you save through a 401(k) at work, then your company’s payroll provider adjusts your paycheck accordingly. You don’t pay capital gains taxes on the earnings while your money grows. However, when you use it after age 59 ½, you will pay taxes on both the original savings and the capital gains at the income tax bracket at that time. Today that is 22% for the $104,000 earner. Notice that the long-term gains are also taxed at the income tax rate and not the capital gains tax rate. Today, the highest income tax rate is 37% while the highest capital gains rate is 20%.
Now, let’s read across to the Roth IRA and Roth 401(k). Think of this as saving from your take-home pay if you are a salaried worker. There is no tax due while the money is growing (capital gains). When you go to use the money, there are no taxes due on your gains. This is in stark contrast to the Taxable, where you pay capital gains taxes on the earnings funded from your net pay.
Finally, in the last column, there is the Health Savings Account. No taxes are ever due if it is used for health expenses. After age 65, if it is used for something other than health expenses, you pay taxes as if it was an IRA.
Unfortunately, some people overstate their retirement savings because they have not accounted for unpaid taxes on their retirement savings. When many people look at their IRA and 401(k) accounts, they equate it to looking at their checking account. The amount you see is the amount that is available to use. Monies saved in a Roth IRA and health savings account, if used for health expenses, can be viewed that way, but not IRA and 401(k) accounts.
Let’s look at this in dollar terms. A Roth IRA of $1,000,000 could be withdrawn, and you would receive $1 million, no matter what the tax rate is at the time. However, based on the 2019 federal tax brackets a $1,000,000 IRA totally withdrawn would receive closer to $719,537. State and local taxes can further reduce that amount. If the account is withdrawn before age 59 1/2 there is likely a 10% penalty too!
As you age, most of us find our cognitive abilities decline. That’s not the time for us to have to start calculating tax rates when withdrawing money. If you’re unfamiliar, it’s already bad enough that you will have to learn the language of Medicare with its part A, part Bs and various Medigap coverages.
If diversification is wise for investing, then it might also be wise to apply that to your retirement savings. Recently, we have seen tax rates go down. They are scheduled to go back up in a few years. If you have saved in different categories, you can use the one most advantageous based upon prevailing tax rates. No one has a crystal ball on making this perfect, but you can potentially save yourself thousands if not hundreds of thousands of dollars in taxes. Recall our $1,000,000 Roth IRA versus IRA example earlier.
Hopefully, this article has helped to clarify the types of ways your money can get taxed. By envisioning your retirement lifestyle, you can plan today to control the impact taxes on retirement savings will have on your future.
The information contained in this material has been derived from sources believed to be reliable but is not guaranteed as to accuracy and completeness and does not purport to be a complete analysis of the materials discussed. None of the information in this document should be considered tax or legal advice. Therefore, you should consult your tax or legal advisor for information concerning your individual situation before investing.
*Tax rates were pulled from the College for Financial Planning’s 2019 Annual Limits.800 × 1574
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