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Dollars & Sense: New Financial Baskets

By Roberta L. Nestor

How many times have we heard the old adage “Don’t put all of your eggs in one basket”?  In the past that advice was specific to making sure you had a well-diversified investment portfolio.  Meaning you wouldn’t want to have 100% of your retirement dollars in one stock, or one holding.  Over the years investment diversification expanded to mean not just stocks and bonds, but having large cap stocks, mid cap and small cap as well as a mix of different types of bonds.  Fast forward and diversification now includes having different asset classes that include international, emerging markets, real estate and non-correlated market sectors.  What is the newest diversification basket?  Tax Diversification.

Baby boomers are retiring at the rate of 10,000 people a day (Investopedia 03/08/2017) and most are learning that tax diversification does not exist in their retirement portfolios.  While many people have multiple sources of income at retirement such as social security, some with pensions and, of course, withdrawals from 401k plans; all of those sources are taxable as ordinary income.  Further, at age 70½ the IRS requires withdrawals from tax deferred retirement plans often pushing retirees into yet higher tax brackets as well as impacting their Medicare premiums.  Not a pretty picture and most retirees will tell you that taxes are their biggest expense in retirement.

Today saving for retirement in a 401k plan offers many choices that will allow you have tax diversification when you retire.  Not all employer sponsored retirement plans offer these options, so check with your employer to make sure you understand what choices have been made available to you.

  • Pre-Tax Contributions – this has been the traditional way to save. You do not pay taxes on your contribution and all of the earnings on your contributions grow tax deferred.  Withdrawals at retirement are taxed as ordinary income.
  • Employer Contributions – if you have an employer match your contribution you do not pay current taxes on these. However, like pre-tax contributions the earnings are tax-deferred and all withdrawals are taxed as ordinary income.
  • After-Tax Contributions – allows you to pay taxes on your contributions now, while the earnings on these contributions grow tax deferred. When you start withdrawals you will only pay tax on the earnings, not on your contributions giving you the opportunity for some tax free income at retirement.
  • Roth 401k Contributions – allows you to pay taxes on your contributions now and the earnings on these contributions grow tax-free (subject to a 5 year hold period). When you start withdrawals from Roth 401k you will not pay any income taxes as you have already paid tax on your contributions and earnings are tax-free.

Tax diversification is very important for your future.  Your first step is to find out what types of contributions your plan allows.  Then you should consult your tax advisor to see what impact changes to your contribution type will have on your taxes.  For example, changing from 100% pre-tax to 100% Roth might affect your tax bracket and may mean having an adjustment on your tax withholding.  If tax-deferral has been built into your tax return for many years, start slow and ask your tax preparer for guidance.

Deferring taxes does have many benefits, especially the accumulation of earnings over decades.   But remember what you are deferring, an unknown tax liability for the future.  It is easier to pay taxes when you are working than when you are retired.  Don’t forget to explore your options with your financial advisor and see the impact it will have at retirement.  Keep your investment baskets and your tax baskets well diversified!

Roberta L. Nestor is a financial advisor practicing at 491 New Haven Avenue in Milford, CT offering retirement, long term care, investment and tax planning services.  She also offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network – a member FINRA/SIPC and a Registered Investment Adviser.  Fixed insurance products offered through Nestor Financial Network are separate and unrelated to Commonwealth. Commonwealth Financial Network or Nestor Financial Network does not provide legal or tax advice.  You should consult a legal or tax professional regarding your individual situation.  Roberta can be reached at Nestor Financial Network, 203-876-8066 or roberta@nestorfinancial.com.

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