You have almost certainly heard that you should not keep all of your eggs in one basket. In investing, this refers to the power of diversifying your investment portfolio and minimizing the risk from any individual stock, bond, or mutual fund. However, investors also need to consider the importance of tax diversification.
The U.S. national debt has eclipsed $28 trillion. With progressive spending bills in the works, total debt levels are likely to grow. If taxpayers alone were to foot the current bill, it would equate to a payment of nearly $200,000 per person. Coupled with historically high and increasing debt levels, marginal income tax rates at the federal level are the lowest they have been in decades. The wealthiest Americans today pay a marginal income tax rate of 37%. In the mid-20th century, this marginal rate ranged from 70 – 92%.
401(K)s were first introduced in 1978. Since then, employees have poured their retirement savings into workplace plans. Traditional 401(K) plans allow savers to get a tax deduction on current contributions, allow the investments to grow tax-deferred, and pay taxes at a lower tax bracket during retirement. This strategy has been largely successful. Most people enter retirement receiving less income than during their working years, putting them in a lower tax bracket. However, what if tax rates increase across all marginal levels? A retiree could find themselves in the same – or higher – tax bracket than during their working years.
There are several strategies that can implemented by investors to diversify the tax risk in their total portfolio. They largely involve paying taxes today, when the tax consequences are certain and defined, rather than paying an undetermined and potentially higher rate during retirement. The most straight forward strategy is to make a Roth IRA contribution. Roth IRAs allow working individuals to make after-tax contributions of up to $6,000 per year. These contributions grow tax-deferred and can be withdrawn tax-free in retirement. Individuals aged fifty and over can make an additional catch-up contribution of $1,000 per year. Roth IRAs are subject to income limitations and the ability to contribute phases out for high earners.
Many employers offer Roth 401(K) plans as a way for employees to save a nest egg of tax-free dollars in excess of their contributions to a Roth IRA. The $6,000 contribution limit for Roth IRAs can be a bottleneck for individuals looking to stow away larger, tax-free retirement sums. Therefore, the Roth 401(K) allows for contributions of $19,500 per year, with a $6,500 catch-up for employees aged fifty and older.
A lesser-known strategy for maximizing after-tax savings is to utilize after-tax contributions in a 401(K). Separate from 401(K) or Roth 401(K) contribution of $19,500, or catch-up contribution of $6,500, an after-tax 401(K) contribution allows an employee to contribute up to $38,500, or $45,000 if aged fifty or older. These after-tax contributions are limited by employer contributions. For example, if an employer contributes $10,000 to a forty-seven-year old’s 401(K), that person would be capped at an after-tax contribution of $28,500 for the year. Not all employer’s offer this feature with traditional 401(K) plan.
It is important to note that earnings on after-tax contributions grow tax-deferred but are taxable upon withdrawal, like a traditional pre-tax contribution to a 401(k) plan. For example, if an employee contributed $20,000 after-tax to their 401(K) and the balance grew to $25,000, the $5,000 in gains would be taxable upon withdrawal. In-service withdrawals allow employees aged 59 & 1/2 or older to roll both after-tax dollars and pre-tax gains out of a workplace retirement plan. However, if the employee is under aged 59 & 1/2, normally only the after-tax contributions are eligible for withdrawal or rollover.
In conclusion, the importance of not keeping all your eggs in one basket applies to more than basic portfolio diversification. Investors need to be aware of the tax ramifications of their savings strategies. Roth IRA & 401(k) contributions can be used to balance out pretax savings. After-tax 401(K) contributions and Roth conversion strategies can propel the savings even farther. Investors should consider consulting a tax or financial planning professional to create a personalized tax planning strategy.
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