Most people think about their retirement, but not everyone plans for it. They think everything will be fine if they sign up for their employer's 401(K) or that they will have enough to retire through Social Security alone. Some workers may do just fine with their employer's retirement or pension plan and Social Security checks during retirement. However, relying exclusively on automatic participation in these types of plans may not always earn retirees enough money or it might cost them a lot of investment earnings during tax time.
Income Tax Rates, Career Length and Social Security Withdrawal
Depending on one's career length and when an individual takes social security payments, weighing the benefits of a tax-deferred retirement account versus one with tax-free earnings can determine which account is right for an individual.
If an individual wants to work past 70 ½ years old, when distributions are required, the total projected income must be estimated. Working past required distribution age may put a tax-payer into a different tax bracket, especially when taking into account not all Social Security benefits may not be taxed. Tax-free growth accounts, such as a Roth IRA or Roth 401(K), may be more advantageous for individuals forecast to work past the traditional retirement age of 65 versus a traditional 401(K) or IRA that provides savers with immediate tax savings.
Long-Term Tax Forecast
If some experts are right and the $17-trillion (and growing) national debt needs to be reigned in, federal income tax and capital gains taxes may be raised in the near future.
Individuals need to weigh their projected future financial situations against their projected tax rates during retirement (or if one works during retirement). For example, many Roth IRAs and 401(k)s give retirees tax free growth, providing retirees insulation against higher federal and state income tax rates. However, traditional IRA and 401(k) accounts may be taxed at higher or lower income tax rates depending on future federal and applicable state income tax rates – especially if they work during retirement, even though some Social Security and pension benefits may not be taxed.
Dividend Intensive Investments
If a retiree has a lot of investments that produce dividends, which are reinvested, tax-deferred growth accounts may be a better deal depending on the individual's career length. Tax-deferred investment accounts, such as a traditional 401(K) or IRA may provide advantageous if a retiree's tax rate is lower up retirement.
The following example illustrates the point:
Individuals who take advantage of the tax deferred retirement savings account can take advantage compounding, even though the earnings may be taxed, albeit at hopefully a lower rate than their current income tax rate for long, but especially short-term income rates.
One example would be investing $2,500 in an exchange-trade-fund or mutual fund that gives dividends of $500. Along with taking advantage of the reinvestment, there would be an additional reinvestment of the money that would have gone to taxes, but would instead go back into the mutual fund or ETF.
Individuals using a pre-tax IRA or 401(k) would be better positioned to benefit from it in the long term, compared to Roth IRA or 401(k) accounts. Traditional IRA and 401(k) account holders have the potential to compound more money through untaxed income over time, along with the potential to fall into a lower tax bracket depending on how much income is taxable during retirement (Social Security benefits, pensions, etc.)
Over decades, the compounding would be far more impactful from a tax deferred account, especially when distributions would only be required at 70 ½, instead of when the mutual fund or stock is sold and taxed at long- or short-term tax rates.
While most of us can't predict our financial and professional lives during retirement or what tax and interest rates will be 10 or 30 years from now, prudent planning can increase the chances of having more choices during retirement.