In Retirement It’s All About Your After Tax Income
It’s Not How Much Money You’ve Saved... In retirement it’s all about your after-tax income Several years ago, ING ran a series of commercials about “Your Number,” showing people carrying around and nurturing their retirement account balance as if it were a baby or a pet. It was a cute and clever marketing campaign suggesting that each of us has an ideal amount to have saved by retirement, and that we should focus on finding it. Much has been written about the perfect number, and I get asked all they time by investors if they have saved enough.
But what if I told you that retirement income has little to do with how much you have saved and everything to do with where you have saved it? Saving is hugely important and necessary, but saving in the wrong types of accounts will doom you to potentially less after-tax income in retirement as income tax rates rise to address $22 trillion in debt (and growing), and the insolvency of Social Security and Medicare, among other issues.
Investing in traditional 401(k)s and IRAs offer you the opportunity to receive a tax deduction for your contributions today and defer paying taxes on the growth of those accounts until you retire. By investing, over time, you will grow these accounts to a much larger size. In retirement, distributions from IRAs and 401(k)s will be taxed as ordinary income – hitting the same tax brackets as when you were working. It is an amazingly effective taxation strategy because the Federal Government knows it will receive a handsome return on their initial “investment” by taxing the income from your savings over your entire retirement, and possibly into the next generation.
Because they defer your taxation, and because taxes are likely to increase to address our fiscal challenges, traditional 401(k)s and IRAs are not ideal for savings over the long term. So, what are the alternatives? Roth 401(k)s and Roth IRAs. Savings in these types of accounts offer no upfront tax deductions, but all growth and income will be tax-free in retirement. What a great deal. You can even convert some or all of your existing IRAs into Roth IRAs by paying the tax due on that conversion at today’s historically low tax rates. By doing so, growth and distributions from those accounts will never be taxed again as tax rates increase.
Maybe you aspire to have $1 million saved by retirement. Maybe you already have that much in retirement savings. Here is an important question: which is worth more, $1 million of taxable assets or $1 million of tax-free assets? Saving and investing in the right types of accounts can produce higher after-tax income in retirement. That should be your goal.