Retirement Tax Buckets: Plant the Right Seeds this Spring

TL;DR For many of us, saving solely through a 401(k) will not result in the financial flexibility we need.

Traditional retirement accounts like employer-sponsored 401(k)s are a large part of retirement savings, but there are benefits to using multiple account types. Contributing to accounts outside of your employer’s 401(k) not only gives you greater investment choice, but can free you from: age restrictions on withdrawals, administrative burdens of RMDs, and valuable tax flexibility.

1. Roth IRA Accounts

Roth IRA’s are retirement accounts that are funded with already taxed dollars but the earnings can be completely tax free (if all rules are followed). This is the opposite of traditional retirement accounts like 401(k)s and IRAs where the taxes are incurred on the contributions AND earnings upon withdrawal.

Roth IRAs have the same age restrictions as traditional retirement vehicles like 401(k)s and traditional IRAs: you must wait until age 59 ½ to make a withdrawal without a penalty. However, Roth IRAs allow you to take out your contributions at any time.
Roth IRAs have a 5-year rule in addition to the age requirement: An investor must have owned the Roth IRA account for 5 years in order to make a withdrawal of earnings after the first contribution. If you are age 55 or over, it's not too late. Consider opening a Roth IRA now to get those five years tolling. There is no contribution minimum!
A smart tax planning strategy at any age is to annually convert funds from a traditional IRA to a Roth IRA. You will pay taxes on the funds that are converted, so plan carefully with your advisor or tax professional. Why convert to a Roth IRA? Because IRA distributions will always be taxed. If you wait until retirement, you no longer have income to pay the taxes. Instead the taxes are paid out of your retirement funds, thus dwindling your finite retirement income. Moving IRA assets to a Roth IRA stops the tax on the earnings and creates a free source of income later in life. Your beneficiaries will also inherit the funds tax free if you do not spend it all.

Want to avoid dealing with these rules later in life? Start contributing to a Roth IRA now.

You can avoid the administrative burden of all these rules by starting contributions to your Roth IRA at a younger age. The result will be fewer of your retirement funds concentrated in tax deferred 401(k)s or traditional IRAs.

For more details on the benefits of Roth IRA accounts, read advisor Danielle Woods’ Roth IRA: How to Maximize This Wonderful Tool in 2023.

2. Taxable Brokerage Accounts

A brokerage account offers the greatest flexibility for retirement savers, but do not offer the annual tax advantages of retirement accounts. When invested properly, financial advisors can help with tax efficiency by selecting the right investments and taking advantage of strategies like tax loss (or gain) harvesting. Propel can replicate the convenience of automatic contributions to a 401(k) through automatic electronic transfers from your bank to your brokerage account.

3. Traditional 401(k)s

Employer 401(k)s are convenient because they can be easy to set up and will auto draft regular contributions straight from your paycheck. Many employers offer matching funds. This is free money that employees should be taking advantage of. We generally recommend participating in your employer plan at least to the point where you earn the employer match.

We dive into more details on strategies for these accounts in Episode 12 of our Connecting the Dollars podcast: Eye on Estate Planning - Strategic Use of Investment Accounts