Most women I talk to are more concerned about paying less in taxes today than when they retire. I believe they should shift their focus to paying less over their lifetime.
Many women like the idea of paying less in taxes, but how does that relate to a financially free retirement? To illustrate, we’ll examine retirement taxation using a regular aka taxable account, an IRA and a Roth IRA.
Individual Retirement Arrangement (IRA)
Assume a $5000 annual IRA contribution over 20 years. Most people pay that from their checkbook from money that has already been taxed. When you file your taxes, the taxes you paid are credited back to you. This turns after tax dollars into pre-tax dollars. Assuming that you make 10% on that money over 20 years. All of those returns are not taxed, well not while your account balance is growing.
Roth Individual Retirement Arrangement (Roth)
Now, let’s do the same making a Roth IRA contribution. We’ll make that same $5000 annual IRA contribution over 20 years. You pay from your checkbook from money that has already been taxed. When you file your taxes, there is no crediting of the taxes you paid.
Let’s assume that you make 10% on that money over 20 years. All of those returns are not taxed, nor will they ever be again given that you don’t violate the holding rules. Those rules are mainly hold for at least 5 years and don’t use before age 59 ½.
Some women that I speak with don’t like the age 59 ½ restriction rules on retirement advantaged savings. “What if I want to use it for something else” some say. What if I just save the $5000 in a regular account. In that case, let’s understand how that money is taxed.
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Regular account aka taxable or brokerage account
Examining the difference between short-term and long-term capital gains. If you invest in something and make money on it over time, you would be taxed on those gains.
If your gain is considered short-term – that is, you’re invested in it for less than 1 year — you will be taxed on the profit at your marginal tax rates for the year.
If your gains are for a period over one year, they are considered long-term capital gains, and are taxed at what could be a more favorable 20% rate.
Let’s say you invested in stock it makes $600 in six months and you sell it. You are subject to taxable gain at your marginal income tax rate. If you wait 367 days, the gain becomes long-term. Historically, that has been a lower rate than the marginal income tax rate. In 2022, the highest marginal income tax rate is 37%, the highest long-term capital gains rate is 20%.
If you invest using a fund you may find yourself paying both short- and long-term capital gains taxes. Those taxes may be assessed even if you don’t hold the mutual fund for the entire year. The reason is that some of the gains may have been embedded inside of the buying and selling activity of the mutual fund. Think of it as you getting stuck holding the check.
The IRA and its siblings and cousins, SEP IRA, SIMPLE IRA, 401(k), 403(b), tax sheltered annuity (TSA), 457 plans offer “tax-deferral”. In this case, there is no long-term gains rate.
When the money is withdrawn, you will pay at the then prevailing income tax rate(s). Tax deferred does not mean not having to pay taxes. It means delaying taxes. That delay may involve you paying a higher tax rate in the future than you would have paid if you paid today.
IRA vs Roth vs Taxable Tax Results
To illustrate, let’s examine a hypothetical situation where I used Envestnet MoneyGuide Elite software. Roberta, is 37 and will retire at 67. She saves the maximum she can save every year to qualify for the pre-tax benefit.
In 2022, that is $6000. That number typically gets adjusted up every so often to keep up with inflation. I assume a 5.37% rate of return. At the end of her 66th year, she has the following amounts saved up:
- Taxable account $461,032
- IRA $596,956
- Roth IRA $596,956
Capital gains taxes reduce the accumulation of the taxable account by an estimated $137,000. The IRA and Roth are equal. However, the year after any withdrawals on the IRA are taxed. Let’s say, Roberta wants to pull out $100,000. She would need to withdraw $125,000 in order to net that amount if her combined Federal, state and local tax rate was 20%. That same withdrawal from a Roth, would be $100,000.
Wishing you could merge the pre-tax benefits of the IRA with the no tax on withdrawal? You can through a health savings account. You can learn more about using the health savings account in my article, “Want A Discount On Your Retirement Healthcare? Use An HSA”
In short, you save money to pay for health care expenses. If it is spent on health care, there are no taxes ever. You don’t have to wait until age 59 ½ to use the money. However, the longer you wait to use the account, the more time you have for the money to compound its growth. It has a limit of $3550 in 2022 for singles and doubles that for married households.
Using a Roth IRA and a health savings account you can withdraw dollar for dollar with no thought on a cost for taxes. That is not the case with the IRA, its siblings and cousins. When you go to the IRA ATM to pull out a dollar, taxes will be paid. The more you pull out you may pay even more in taxes because you have crossed into a new tax tier.
Some people find themselves need to deal with required minimum distributions demanding greater withdrawals than needed for lifestyle spending. While you don’t have to spend the money, you do have to pay taxes on it. If you decided to reinvest it into a taxable account, you will now be dealing with capital gains taxes.
Use tax smart investing that support your retirement dreams
Taxes are certainly a major factor in not only maintaining lifestyle but also not running out of money. If you have guaranteed income sources like pensions and Social Security, you can run short of money. It’s important to consider the tax impact of your savings as soon as you can.
Depending on your income you may find yourself limited today but with options to change tomorrow. It’s important to know how to treat each account to maximize each.
I believe the best way is to start with a personalized financial plan. This way you can best see the effects of each and to develop the right balance for yourself. Don’t let unnecessary taxes ruin your retirement dreams!