Realize America’s Tax Situation
Obviously first you must assess our tax situation for yourself. You need to know how taxes are affecting you today, and how they might affect you in the future. This may seem simple, but put some thought into what size portfolio you are attempting to build or how much money you plan to withdraw each year during retirement. These would affect what tax rate you might get hit with.
Avoid Tax-Deductible Retirement Accounts
This may seem insane, but I would stop contributing to my tax-deductible retirement accounts. In fact I’ve done just that. For the average American these tax-deductible retirements accounts are traditional 401k and traditional IRA accounts.
Here’s how these tax-deductible accounts work. Your paycheck is typically $1,000 before taxes and fall in the 25% tax bracket. Normally you would pay $250 in taxes and you would net $750. Now if you put $100 into your tax-deductible account your before-tax amount would fall to $900 and your taxes would drop to $225. You would net $675. You just saved $25 in taxes.
That sounds great, right? You just saved $25 for free.
But you’ve got to pay those taxes when you retire and start withdrawing those funds for your annual income. That’s all well and good if your tax rate is the same or less than it was when you initially put the money into the account.
Remember, tax rates have to go up eventually. Our government cannot continue to print IOUs. We, as a nation, have to bring in additional income to pay for our deficits. What if your tax rate is 30%, 40%, or 50% when you retire?
You had the option of paying at 25% and knowing what the cost would be. Waiting may turn out in your favor… then again with our budget deficits it may not. I’d rather pay now and know that I won’t have to pay again.
Don’t Forget to Get Your Match
Don’t drop your 401k completely. You still need to get any employer match offered. Unfortunately in this economy many employers have slashed or eliminated their match so perhaps this isn’t as big of a deal for you.
But if you’re still getting a match make sure you continue to contribute just enough to get the full match. Otherwise you are leaving money on the table.
Other Investment Options
Primarily you will be looking at after-tax retirement options. The best option available to almost everyone is the Roth IRA.Â I say almost everyone because your ability to contribute to a Roth IRA is limited by your income. As a single person if you make less than $105,000 per year you’ll have no problem contributing the maximum amount of $5,000 per year ($6,000 if you are age 50 or above). From $105k to $120k your ability to contribute is slowly reduced. From $120,001 on up you won’t be able to use a Roth IRA.
Your Roth IRA is funded with post-tax money, so you’ve already paid tax on it. This means you won’t pay federal income tax on the money ever again. (Although I’m not holding my breath. I’m sure they could figure out some new way to tax you on it again!)
No need for fancy accounting to figure out how much your portfolio is really worth after taxes. Just look at the total. That’s how much it is worth. (State tax situations will, naturally, vary by state.)
The Roth 401k is slowly growing in popularity. Unlike the Roth IRA you can’t give yourself this option. You must wait (or encourage!) your employer to adopt it.
What’s the difference between a Roth 401k and a Traditional 401k? The same as the difference between Traditional IRAs and Roth IRAs. A Roth 401k is a post-tax retirement account. Money is deposited directly from your paycheck into the account and your employer picks who runs the account.
My employer offers this option and it is what I use. (Unfortunately since our 401k match is pathetic I only contribute enough to get the match.)
Prepare for Tomorrow… Today
It is easy to mentally dismiss your tax planning for retirement. For many of you that is 10, 20, or 30 years down the road. But just as with any other type of financial planning the steps you take today will make your life that much easier tomorrow.
Even if tomorrow is in thirty years.