Many Americans dream of early retirement, but only a select few actually achieve it. And what’s not to love? Early retirement offers:
- The freedom to spend your time how you wish
- The freedom to pursue the activities that most fulfill you
- More quality time to spend with your friends and family members
- Financial freedom and security (if properly planned for)
- Greater opportunities to travel when you’re young and healthy
- The option to work rather than the obligation
To achieve early retirement, you must be prepared to engage in careful planning, strategic investing, creative methods to limit expenses, and enthusiastic, ongoing dedication to the end goal. Although this article isn’t about how to retire early (more on that to come!), I recognize that more Americans are striving for early retirement now than at any point in the previous 10 years.
Indeed, I have helped many of my clients with their goal to retire early through meticulous planning and implementation of prudent strategies.
For those aspiring to early retirement, it’s important to remember that two of the highest expenses in retirement are healthcare and taxes. In this article, I’ll discuss how taking advantage of different retirement savings vehicles can help to diversify how and when your retirement income will be taxed, with the overall goal of reducing your lifetime tax obligations.
Tax-Deferred & Tax-Exempt: Traditional Vs. Roth
The two most common types of retirement savings vehicles for tax diversification are tax-deferred accounts and tax-exempt accounts.
Tax-deferred accounts allow you to contribute pre-tax income to retirement savings and therefore reduce your taxable income in the years you make contributions. You’ll then pay income taxes on that money later when you take withdrawals from these accounts in retirement. Traditional IRAs and 401(k)s are considered tax-deferred retirement accounts.
Tax-exempt accounts, on the other hand, permit you to make contributions with after-tax dollars. There are no upfront tax benefits when contributing to tax-exempt accounts, but since you’ve already paid taxes on those dollars, you will not be taxed on withdrawals made in the future. Roth IRAs and Roth 401(k)s are the most common tax-exempt accounts.
The decision to contribute more savings to tax-deferred accounts or tax-exempt accounts is an entirely personal choice and should be dependent on unique factors within your financial situation.
To help you make an informed decision, keep reading to find out about the specific benefits for tax-deferred accounts and tax-exempt accounts, plus the factors you should consider when determining the right balance for your future needs and goals.
Benefits of Traditional IRAs and 401(k)s
The main benefit to contributing to a tax-deferred account like a traditional IRA or 401(k) is that your taxable earnings for that year are reduced, thus lowering the amount of taxes you have to pay for that year. Additionally, contributing pre-tax dollars allows most investors to contribute more money to their retirement savings in a given year. Because a dollar today is worth more than a dollar tomorrow (due to inflation), giving more of your money more time to benefit from the power of compound interest is one of the best ways to build wealth.
And for some retirees, their income in retirement may be less than the income they earn during their working years (if, for example, the retiree has paid off their mortgage and their expenses are simply lower). If this is the case, their tax bracket in retirement could be lower, so it makes sense to defer those tax obligations to the future when they’re no longer in a high tax bracket.
Benefits of Roth IRAs and Roth 401(k)s
Roth accounts offer a different set of advantages. Roth IRAs first became available in 1988 and quickly gained popularity, especially for younger investors. In 2006, Roth contributions became permissible in employer-sponsored retirement plans like the 401(k) or 403(b) as well.
By contributing after-tax dollars to a Roth account, investors can rest assured that the money they’ve contributed – plus the earnings on those contributions – will never be taxed again (as long as they wait until retirement age to make withdrawals). If tax rates increase, as many experts expect them to do so, paying income taxes now rather than in the future can help retirees save money in taxes over the long run.
To be honest, the expectation that most retirees will be in a lower tax bracket during retirement may be outdated. Many retirees today spend more money to travel and pursue expensive leisure activities in retirement. Their lifestyle expenses may remain the same or even increase in retirement, especially given the current state of healthcare expenses in the United States.
Determining a Balance That’s Right for You
As stated before, choosing whether to contribute to a tax-deferred account or tax-exempt account should depend on a variety of unique factors, so it’s impossible to make specific recommendations without understanding your particular situation. However, below are some common guidelines to think about.
Low-Income Earners
Individuals who are currently earning a low income aren’t in a high tax bracket, so it can make sense to pay taxes on your contributions now when you’re not in a position to benefit substantially from tax deferrals.
Young workers especially may benefit from contributing to tax-exempt Roth accounts when they’re working in entry-level positions in their careers. If current low-income earners expect to increase their income in the future, they’ll save considerably more in taxes by paying those taxes now at a lower tax bracket.
High-Income Earners
High-income earners, on the other hand, may benefit more from contributing to tax-deferred accounts. The immediate benefit to lower their income tax bracket can help them save significantly more in taxes today and allow them to contribute more money to their futures.
Of course, the timeframe for your retirement has an impact on the decisions you make as well. You’ll pay taxes no matter what – but with these two options, you have the freedom to determine when you pay those taxes and which benefits are more advantageous to your situation.
How We Can Help
Ultimately, striking a balance is probably the best decision for most investors who are saving for early retirement. Whether you’re retiring early or just need help figuring out a tax diversification strategy that aims to help you keep more of your income in retirement, the team at Caviness Wealth Management is here to help.
In addition to helping you explore the considerations above, we can help you identify other tax-efficient opportunities and appropriate tax-reduction strategies that are unique to your financial circumstances. To see if we can help you strike the right balance between tax-deferred and tax-exempt retirement savings vehicles, click here to schedule a conversation today.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual.
