Articles Investing for Retirement: Why Taxes Matter

June 4, 2015

"Don't let the tax tail wag the investing dog." It's classic investing advice with a simple meaning: don't make investing decisions based solely on tax considerations. That said, taxes should be at least part of your mindset, particularly when investing for retirement. Here you can learn more about the various types of tax-deferred and taxable retirement accounts.

Primary Types of Tax-advantaged Retirement accounts

The chart below lists the main differences between the primary types of retirement accounts: traditional IRAs and Roth IRAs, and 401(k) and Roth 401(k) accounts. The greatest differences among these accounts is how they treat taxation of your contributions and distributions: essentially, paying taxes now versus paying taxes later. When it's time for you to take distributions (withdrawals) from these accounts, you'll pay taxes on withdrawals from a traditional IRA or 401(k) account, but usually no taxes from a Roth IRA or Roth 401(k), provided certain conditions are met.*

Account Type Types of Contributions Tax Advantages Income Limits Contribution Limits Distributions (Withdrawals)
Traditional individual retirement account (IRA) Before-tax (if you qualify)* Contributions may be tax-deductible None (but ability to deduct contributions potentially limited if you/your spouse participate in an employer-sponsored retirement plan)* 2015/2016: $5,500 ($6,500 if age 50 or older) Must begin by April 1 after the year you turn age 70½; otherwise, penalties (plus taxes) will apply*
Roth individual retirement account (Roth IRA) After-tax At distribution, no federal taxes due, provided certain requirements met* Adjusted gross income must be below certain limits, depending on filing status* 2015/2016: $5,500 ($6,500 if age 50 or older) Withdrawals of contributions available anytime, tax- and penalty-free, provided certain conditions met; no requirement to take distributions*
401(k) account Before-tax With pre-tax contributions, you don't pay federal income tax on the amount contributed to the account 2015: $265,000 2016: $265,000 (Any income above this limit may not be considered when determining employee contributions and matching contributions) 2015: $18,000 2016: $18,000 Ages 50 and older eligible to contribute an additional $5,500 (2014) or $6,000 (2015) Must begin by April 1 after the year you turn age 70½; otherwise, penalties (plus taxes) will apply*
Roth 401(k) account After-tax At distribution: no federal taxes due, provided certain qualifications met* 2015: $265,000 2016: $265,000 (Any income above this limit may not be considered when determining employee contributions and matching contributions) 2015: $18,000 2016: $18,000 Ages 50 and older eligible to contribute an additional $5,500 (2014) or $6,000 (2015) Withdrawals available when permitted by the plan. Assets subject to required minimum distribution rules.*

*Consult with your tax advisor for details.

Tax Deferred vs. Taxable Accounts for Retirement

When you invest in a tax-deferred account such as a Roth IRA, you don't have to pay taxes on your earnings every year, enabling your investment to compound untaxed and enhancing its long-term growth potential. That's why it typically makes sense to max out (up to your annual limit) your contributions to tax-deferred accounts.

That said, there are two primary reasons you may wish to invest for retirement in a taxable account in addition to a tax-deferred account: 1) You've contributed the maximum annual amount possible to all of your tax-deferred account options and still have money left over to invest for retirement; 2) You believe you'll be paying higher taxes in retirement than you do today; if so, you may want to invest in a taxable account and pay taxes on your earnings now, versus paying taxes in retirement on withdrawals from a tax-deferred traditional IRA or 401(k) account.

If you invest for retirement in both tax-deferred and taxable accounts, you may want to keep in mind the types of investments you hold in each type of account. Generally speaking, actively managed stock and bond funds are best owned in a tax-deferred account, because actively managed funds frequently pass along taxable distributions (interest, dividends and capital gains) to their shareholders.

The most optimal investments in a taxable retirement account are generally those that may qualify (if held long enough) for long-term capital gains tax, such as individual stocks, real estate, precious metals, exchange-traded funds (ETFs) and index funds. If you own and sell such investments in a taxable account for a year or less, you'll incur a short-term capital gains tax, which will be identical to your ordinary income tax. However, if you wait more than a year to sell these investments, any earnings are taxed at the long-term capital gains rate, which is 15 percent or 5 percent for individuals in the two lowest income tax brackets.

Big Picture

Regardless of the type of account you choose for your retirement savings, the most important point is that you're taking action now to prepare for your future. Navy Federal Credit Union and Navy Federal Financial Group can help you choose an appropriate course of action.

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