By Patrick Traverse
Your retirement accounts are a great tool to save for your retirement, and you need to make sure that you maximize their benefits. Getting a tax deduction today might sound like a great idea, but is it the best strategy for this year’s contribution?
For many retirees or soon-to-be retirees, the issue of having to take more money out of their traditional IRAs because of required minimum distributions is a real hassle. For others, having to rely on their taxable assets for a large portion of their retirement income needs creates more costs outside of the taxes they have to pay on their withdrawals. Most of them would love to be able to control their current taxes or would have liked to have known the consequences of poor planning.
If you have time on your side and can avoid the mistake of only growing a traditional retirement plan that is fully taxable, take the time to plan on being tax-efficient now and into retirement. Your goal should be to end up with a third (or less) of your assets in traditional retirement accounts, a third (or less) in Roth assets and a third (or more) in liquid taxable accounts. This way you will have money available throughout your life and options when dealing with taxes in retirement. (For related reading, see: 5 Tax(ing) Retirement Mistakes.)
How to Use Your Retirement Account at the Start of Your Career
During the start of your career, you normally earn a lower salary and enjoy a lower tax rate. It is a good time to start using the power of compounding interest and maximizing long-term growth. Using a Roth IRA would enable you to start your tax-free retirement income foundation. Furthermore, savings in a Roth IRA are available before the age of 59.5. You can take your contributions out without penalties. Having a back-up fund for your emergency savings is a great thing.
How to Use Your Retirement Account During the Late Stage of Your Career
Toward the end of your career, you should be enjoying a higher salary. However, higher income also means a higher tax bracket. Now would be the perfect time to use traditional retirement accounts. These accounts would enable you to maximize your deductions and keep taxes as low as possible. As you are getting closer to retirement, your plan should continue to get clearer and give you the ability to adjust if needed.
How to Use Your Retirement Account When You Retire
During retirement, you can continue working on tax efficiency. If you were able to build a good amount of tax-free income, you might be able to convert some of your taxable assets to your Roth option. The idea is to maximize your tax efficiency by topping your income to the edge of your current bracket if it is low.
Once you start collecting your Social Security benefits, tax-free Roth income will help you lower the amount of Social Security benefits being taxed. It could also help you keep Medicare Part B premiums low. Medicare premiums are higher for those who have high gross income. Working on a tax efficiency plan could help you lower these costs.
Tax planning is not only about saving current taxes. It is about having a plan to reduce the effect of taxes during your entire life. These concepts should help you become more flexible before and in retirement.
(For more from this author, see: How to Build Your Financial Foundation.)
This article was originally published on Investopedia.