Optimizing Your Retirement Accounts

Have you heard our team at?Falcon Wealth Advisors ?talk about the different kinds of retirement accounts and wondered if your portfolio is properly optimized? Matthew Tomlin, CFP?, a financial planner on our team, recently joined me on?Upticks ?for the?second time in just a few weeks . We spoke about the different types of retirement accounts and how you can withdraw from them in retirement, what types of assets and investments you should consider, withdrawal strategies and more. We aimed to speak in plain language to discuss this important topic that could help your family potentially save thousands of dollars.

Jake:?There are three main types of retirement accounts: pretax accounts, tax free accounts and taxable accounts. Matthew, can you kick us off by talking about pretax accounts and sharing some examples?

Matthew:?When you contribute to a pretax account, you can deduct the amount you contribute on that year’s tax return. Contributing to a pretax account lowers your tax liability this year, and your contributions to a pretax account will hopefully grow over many years. And you don’t have to pay any taxes on those contributions as they grow. However, you do have to pay ordinary income taxes on every dollar you withdraw from a pretax account—not just your contributions, but all the earnings as well.

Some examples of pretax accounts are traditional individual retirement accounts (IRAs), 401(k)s, 403(b)s, SIMPLE IRAs and?SEP IRAs , which are typically for business owners. A traditional IRA is the only one of these types of accounts that you can contribute to without an employer sponsoring you.

Jake:?Pretax retirement accounts are probably the most common investment vehicle for both corporate executives and business owners. To use an example: If you make $100,000 annually but contribute $20,000 to your 401(k), your taxable income for this year may be lowered to $80,000. This is the primary benefit of using a pretax account.

Many people, especially those who invest in pretax 401(k) accounts at work, assume they’re permanently lowering their tax liability when they contribute to a pretax account. This is not accurate. Contributing to a pretax account?defers?taxes—it does not eliminate them. And beginning at age 72, the government requires you to withdraw a certain percentage of your pretax account, whether you need the money or not. These withdrawals are called required minimum distributions (RMDs) and can even push you into a higher tax bracket than where you want to be in retirement.

And it’s worth noting there are strict rules about when you can withdraw money from a pretax account. Typically, you’re unable to make withdrawals before age 59.5 without incurring a penalty. There are some “loopholes” available, like the?Rule of 55 , but you shouldn’t invest anything in a pretax retirement account that you could need in the near future. With that being said, there are some exceptions that could potentially help someone avoid the IRS penalty, right?

Matthew:?One exception to the IRS penalty is if you’re disabled and need money for medical expenses. Also, first-time home buyers can withdraw up to $10,000 without paying an IRS penalty. And there is some leeway if you need to pay for qualified education expenses.

Jake:?As readers can see, this can all get pretty complicated. That’s why we recommend working with fiduciary wealth advisors like our team at?Falcon Wealth Advisors .

Let’s now discuss tax-free accounts. Can you talk about what they are and share a few examples?

Matthew:?Sure. Examples of tax-free accounts are?Roth IRAs , Roth 401(k)s and Roth 403(b)s. Not every employer-sponsored retirement plan offers a Roth 401(k) or Roth 403(b), however, so you will want to check with your employer.

The big difference between Roth IRAs and the pretax accounts we discussed is that contributing to a Roth IRA doesn’t lower your taxable income this year. To use your previous example, if you make $100,000 and contribute $20,000 to a Roth 401(k), your taxable income stays at $100,000.

While you don’t get a tax benefit this year, the amount the Roth account grows to in retirement can be accessed tax-free, per current IRS law. So if that $20,000 you contribute this year grows to $200,000 over the course of several years, you can access all of that money without paying taxes on it. This is a significant benefit and worth consideration from younger people or anyone who thinks they may be in a higher tax bracket in retirement than they are today.

Because it’s after-tax dollars you’re contributing to Roth accounts, you have a little more flexibility to access the funds at any time.?There are rules associated with accessing your Roth IRA similar to Traditional IRAs. Can you talk about this?

Matthew:?A Roth IRA can almost function as an emergency savings account. While you can’t contribute more than $6,000 a year to a Roth IRA (additional catch up contributions may apply based on age), you can access your contributions at any time and withdraw them from the account without penalty. You cannot withdraw their earnings, however, without incurring a penalty.?(Other?rules ?apply to avoid the penalty)??

Jake:?If you’re reading this and have a couple million dollars in a pretax account and you’re wishing you could take advantage of the benefits of a Roth account, there is a solution called a?Roth conversion . A Roth conversion allows you to take money from a pretax account, pay ordinary income taxes on it, and then convert it into a Roth account where it can grow tax free.

We have many clients in their 50s and 60s who are taking advantage of Roth conversions. We often work with them and determine that while it’s not fun to pay ordinary income taxes on the withdrawals this year, it’s worth it to set those funds up to grow tax free in a Roth account.

Would you also talk about health savings accounts? They can play a role in optimizing retirement accounts.

Matthew:?Yes,?health savings accounts ?offer the benefits of both a pretax and Roth account. When you contribute to them, your contributions may be deducted from that year’s tax return. Plus, any growth in that account can be accessed tax free if you use the money for qualified medical purchases. And beginning at age 65, you can withdraw money from a HSA without penalty for any reason.?(At age 65 the distribution may be taxable though much like an IRA)

Jake:?Yes, there are limitations on HSAs and caps on contributions, but they can be helpful for anyone who envisions having medical expenses as they get older.

Let’s talk about our third category, taxable accounts.

Matthew:?Taxable investment accounts are often called brokerage accounts. There’s no contribution limit to brokerage accounts and you can withdraw as much as you want at any time. But you do have to pay capital gains taxes on any growth you see in that account; you have to either pay short-term capital gains or long-term capital gains based on how long you’ve had the account. And a taxable account can only be funded with dollars that have already been taxed.

Jake:?Yes, you do have to pay taxes on any gains you realize in the account—but you can also potentially write off any losses. Checking accounts, savings accounts, investment accounts and trusts are all taxable accounts. What we typically help clients open and use are taxable investment accounts, which can be especially helpful for people who want to retire before 59.5. If you want to retire young, it’s important to have money you can access without paying an IRS penalty.

I think a taxable investment account can be considered a “second layer savings account.” If you have three to six months worth of expenses in a savings account at your bank, you could then use a taxable investment account with the aim of growing your wealth. Of course, there’s more risk associated with investing than leaving money in a savings account.

To summarize what we’ve talked about so far, there are three different categories of investment vehicles: pretax accounts, tax free accounts and taxable accounts. Matthew, whether someone is 25 or 55, which of these accounts should they use to optimize their retirement savings?

Matthew:?It depends on their tax situation and the goals of their financial plan. Someone in a high tax bracket may want to contribute to a pretax account this year if they expect to be in a lower tax bracket in retirement. Meanwhile, someone in a lower bracket may want to go ahead and pay today.

Ideally, for tax diversification purposes, a?Falcon Wealth Advisors ?client would have money in each of these three buckets. If you have money in each of these three buckets, we will have more tax planning flexibility for you in retirement.

Jake:?Well said. And in an ideal world, a client would have their portfolio equally distributed among these three types of accounts. Do you agree?

Matthew:?Absolutely. Having money equally distributed between three types of accounts would give us some flexibility to limit your tax liability.

Jake:?That’s why at?Falcon Wealth Advisors ?we like to review a client’s tax return every year. We can then help direct them to the right investment vehicles for their situation. Of course, it’s worth noting our advice can evolve as your life and tax bracket changes.

Relatedly, while in an ideal world a client would have the same amount of money in all three of these buckets, that doesn’t mean people working should contribute a third of the money they’re able to save to each. As we discussed, if you’re younger and in a low tax bracket, it may make sense to invest the vast majority of your savings into a Roth account. Or if you are 55 and you’re planning to retire at 60 and you have no money in a Roth account, it may make sense to go ahead and try to build up some money in a Roth. Contributing to a Roth—even later in your career—or pursuing Roth conversions can help minimize the impact of those required minimum distributions we discussed. No matter your age, it’s not too late to explore how you can benefit from a Roth account.

Let’s now talk about asset location. I think a common misconception from investors is that all three of the types of accounts we’ve discussed today should be invested the same way and perform the same way. At?Falcon Wealth Advisors , why don’t we buy the same types of investments for these three types of accounts?

Matthew:?We want to leverage the benefits of each type of account. For example, let’s say you have a Roth account and those earnings are growing tax free. It likely makes sense to invest higher-upside investments in it, rather than bonds, because if you are fortunate enough to have a stock that performs exceptionally well, that growth will be tax free.

Jake:?Exactly. Bonds are of course a pivotal part of a financial plan, but we want to maximize the benefits of a Roth account. It doesn’t make a lot of sense to put a tax-free bond in a Roth account.

Matthew:?That’s correct, as these types of bonds already offer tax benefits. Like you said, we want to maximize the tax benefits of each investment vehicle.

Jake:?If you have a tax-free municipal bond in a Roth or pretax IRA, that’s not ideal. Please call our team at?Falcon Wealth Advisors ?if that’s the case and we can explore ways to improve your tax situation.

A big takeaway from the concept of asset location for our clients should be that if you have multiple accounts with us, you shouldn’t expect them to look the exact same way—and the performance in each account won’t necessarily be the same. Our team reviews your entire portfolio and optimizes it to leverage the benefits of these different types of accounts.

Let’s talk about withdrawals. If a client has a million dollars in each of these three types of accounts, which one should they pull from?

Matthew:?This will vary from person to person based on their financial plan and tax situation. But in the example you share, we may help the client withdraw from their pretax account—but not withdraw so much that it pushes them into a less favorite tax bracket. And if the client needs additional income, we can withdraw from a Roth or brokerage account.

This is an important strategy, because ensuring your taxable income isn’t too high is especially critical after age 65, when having a higher taxable income could lead to an increase in cost of your Medicare premiums.

Jake:?Yes, and speaking of taxable income, I’m excited we have some new tax planning software that allows us to examine your tax return and offer customized tax planning advice. While we are not tax advisors at?Falcon Wealth Advisors , we do take tax planning seriously. I believe this is something that separates us from other advisors. If you would like to learn more about everything we offer clients and how we can optimize your retirement accounts, please contact us today. You can contact me directly at?[email protected] .

Clients choose to work with us to enhance their financial literacy and explain exactly what?their?financial plan means to?them.

Hightower Advisors, LLC is an SEC registered investment adviser. Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.