Many investors are not saving enough for retirement and, unfortunately, the current tax environment isn't helping.
Setting money aside consistently is an important step in saving for retirement. However, making investment-account choices without considering all of the options and tax implications could result in unwelcome surprises later.
If you want to get the most out of your retirement savings, you'll need to take an innovative approach to using various investment vehicles, and be deliberate about asset location decisions to take full advantage of the different tax treatment afforded to different types of accounts.
Investors Face Savings and Tax Challenges
If you're like most Americans when it comes to saving for retirement, you're probably not doing enough. According to a 2016 study by the Employee Benefit Research Institute, only 69% of Americans are saving for retirement at all, and only 21% feel very confident that they will have enough money to live comfortably in retirement.
Taxes make saving even more challenging, as recent legislation increased income tax rates for wealthy Americans.
In 2013, provisions in the American Taxpayer Relief Act (ATRA) raised the top federal income tax bracket to 39.6% for ordinary income, and increased the top tax rate for qualified dividends and long-term capital gains to 20%. For 2017, these highest brackets, which are adjusted annually for inflation, will affect taxpayers with taxable income of $418,000 and above (single) or $470,700 and above (married filing jointly).
Provisions in the Affordable Care Act (ACA) that took effect in 2013 increased both Medicare payroll taxes and added a new 3.8% surtax on net investment income for taxpayers with adjusted gross income (AGI) of more than $200,000 (single) or $250,000 (married filing jointly).2 The AGI threshold is not adjusted for inflation.
These changes mean that you might now find yourself in a higher tax bracket or subject to significant additional taxes.
Confronting The Challenges
Regardless of the impact of higher taxes or the potential for new taxes in the future, sound retirement planning starts with an objective assessment of your long-term needs and goals.
Objective-driven investing involves first identifying the amount needed to maintain your lifestyle in retirement along with amounts you'd like to transfer to future generations or leave as legacy gifts to charitable organizations.
Once you have identified your goals and have taken an objective and realistic look at what you can set aside to save toward meeting them, you'll need to identify and incorporate investment strategies designed to help you succeed in meeting your goals.
However, with different tax implications for retirement savings vehicles, simply identifying an investment strategy isn't enough. Retirement plans and savings vehicles provide unique options, so it is important to evaluate and select the those vehicles to address your specific circumstances.
Traditional vs. Roth IRAs
Consider how taxes are applied differently in traditional IRAs and Roth accounts.
Distributions from traditional IRAs are taxed as ordinary income and may be subject to higher income tax rates — up to 39.6%. In addition, though there is no net investment income surtax on the distributions because the distributions are included in the AGI calculation, they can result in subjecting a portion of other non-IRA investment income to the 3.8% surtax for those who exceed the AGI threshold.
In contrast, qualified distributions from Roth IRAs are tax free and not included in the AGI calculation. Moreover, Roth IRAs do not require a required minimum distribution (RMD) after you've reached age 70 ½, so your Roth IRA can continue to enjoy tax-deferred growth.
Tax-law changes in 2013 expanded Roth 401(k) conversion rules, allowing for conversions from traditional 401(k) or 403(b) plan accounts to Roth 401(k) accounts if an investor's employer-sponsored plan offers a Roth 401(k) option, and if the plan allows for conversions.
While Roth 401(k) accounts may not benefit everyone, the tax planning and wealth accumulation benefits are worth considering since Roth 401(k) accounts allow for tax-free growth and tax-free distributions.
For those expecting to be in a higher income-tax bracket in the future, a Roth account might make sense. If you are considering a Roth conversion, a thorough evaluation of the tax implications with your tax advisor is critical. Converting to a Roth account does require immediate taxation of any previously untaxed amounts in the year of conversion.
Optimize Savings by Making the Right Investments in the Right Accounts
While tax-deferred saving may ward off current taxes, it is also important to maintain a balance between taxable and tax-deferred accounts. Investing too much in tax-deferred vehicles could inadvertently lead to higher taxes due during retirement.
Asset location (not to be confused with asset allocation) refers to the process of optimizing your overall after-tax results by distributing assets and asset classes across different types of accounts and investment vehicles. Ultimately, the goal of asset location is to use investment accounts with tax-deferred protection to hold investments that are most likely to incur higher taxes, such as investments with higher capital gains potential.
While investors have unique financial circumstances, often the characteristics of specific investments lend themselves to often being placed in certain vehicles. For example, assets that may offer benefits when placed in tax-deferred accounts include:
Short-term bonds (which are subject to ordinary tax rates)
Real estate investment trusts (REITs)
Hedge funds Actively-managed equities (which often make significant taxable distributions)
On the other hand, large-cap equities and stocks with little or no dividends, along with municipal bonds with tax-free income, should generally be placed in taxable accounts.
The Sooner You Confront These Challenges, the Better
Saving for retirement, especially in today's complex tax landscape, is a challenge. But, by approaching that challenge deliberately and thoughtfully, and by reviewing and making adjustments as needed, you can be confident that you're on the right path.