Yes, Your 401(k) Has Its Perks, But It’s Not the Only Way to Save

There’s no doubt tax-deferred investment accounts, such as 401(k)s, 403(b)s, 457 plans, and traditional IRAs can play a valuable role in most any retirement savings plan.

Not only do these accounts offer the immediate incentive of an upfront tax break, but workers also often can benefit from employer contributions.

I can’t think of too many financial experts who would tell you to pass on getting that “free” money from your company – or the opportunity to save on taxes each year as you work to grow your nest egg.

From just $107.88 $24.99 for Kiplinger Personal Finance

Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues

CLICK FOR FREE ISSUE

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

That doesn’t mean, however, that tax-deferred accounts should be the one and only way you save.

Remember: Every dollar withdrawn from a 401(k) or similar plan during retirement is considered ordinary income — which means it’s subject to ordinary income tax. If the bulk of your savings is stashed away in a tax-deferred account, you could be facing some scary-high tax bills in the future when you begin taking withdrawals.

Fortunately, other options exist for investing and saving for retirement — and options are always a good thing to have. Even if you’re nearing retirement and a sizable chunk of your retirement savings is currently sitting in a tax-deferred account (or accounts), you still can build some tax diversification into your plan.

3 Buckets for Tax Diversification

You can create that diversification (by yourself or with the help of your financial adviser) by dividing your assets into different tax “buckets”:

• A tax-deferred bucket that includes the funds in those aforementioned 401(k)s, 403(b)s, IRAs and similar accounts that will be taxed as ordinary income (based on your current tax bracket) as you make withdrawals.
• A taxable bucket that includes bank accounts, brokerage accounts and other investments that are taxed currently, but often at a preferential rate. (Most people, for example, pay a 15% tax rate on the net capital gains and qualified dividends earned annually from taxable investment accounts.)
• A tax-free bucket that includes Roth IRAs, Roth 401(k)s, properly structured cash value life insurance policies and municipal bonds, which are tax-free upon withdrawal.

By spreading your money among these buckets, you’ll have more flexibility with your withdrawals. You can more easily control which tax bracket you’ll land in from year to year and, therefore, how much you’ll pay in taxes.

Flexibility is always a plus when it comes to financial planning. But the ability to manage your tax bracket could become especially important if tax rates rise in the future, as many experts are predicting. And we already know the current tax brackets and lower income tax rates brought to you by the Tax Cuts and Jobs Act of 2017 are set to expire at the end of 2025.

How Those Buckets Could Save You on Taxes

If your financial professional — or a tax-savvy friend — has been pushing you to do a Roth conversion in recent years, this is likely the reason. So, let’s look at a basic hypothetical example of what adding a Roth IRA to your plan could mean going forward.

Let’s say you withdraw $50,000 from your 401(k) and, combined with your other income sources, that puts you in a bracket that’s taxed at 24% (based on current rates). You could end up handing $12,000 to the IRS, leaving you with $38,000.

But what if, instead, you were able to split that $50,000 withdrawal between two accounts. You withdrew $25,000 from a tax-free Roth and the other $25,000 from the tax-deferred 401(k)? You wouldn’t owe any taxes on the Roth withdrawal (if you’ve followed the Roth rules), and because the move likely would keep you in a lower tax bracket, you’d pay less in taxes on the 401(k) withdrawal. If you stayed in a bracket with a 12% tax rate, for example, you’d owe the IRS just $3,000 on the money you took from the 401(k).

That’s a substantial savings.

The Bottom Line

Unfortunately, I can’t tell you the ideal proportion of savings to keep in each tax bucket as you build tax diversification into your retirement plan. The right mix for you will be determined by your individual needs and goals. And the amount you withdraw from the accounts in each of those buckets will probably vary from year to year, as the situation requires.

I can tell you, though, that having a carefully planned, diverse mix of tax-deferred, taxable and tax-free accounts in the distribution phase of your financial life can be as important as having a carefully planned, diverse mix of assets in the accumulation phase.

Have you been loading most of your savings into tax-deferred accounts? Talk to your financial adviser about the benefits of contributing to a Roth or, if you’re older, converting some funds to a Roth account over the next few years. Consider, too, how a brokerage account, life insurance and other investments could benefit your overall plan. And make sure you look at how your annual investment withdrawals might work in combination with other income sources, such as Social Security and pensions.

If you’re hoping to extend the life of your portfolio (and who isn’t?), tax planning is a must.

Kim Franke-Folstad contributed to this article.