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Tax Me Now, Tax Me Later, Tax Me Never

401(k) 401k roth tax
 

Being smart about which type of accounts you're saving and building wealth into now translates into paying less tax later, and who doesn't want that?

I'm Yvonne Marsh, I'm a CFP® and a CPA, and I've really spent my financial planning career helping people diffuse the tax time bomb that they've accidentally built up in their 401(k)! They didn't realize that that tax deduction they were getting for making those 401(k) contributions was going to turn around and sort of bite them in the end when they retire. This is because all the money they were taking out of their 401(k) to then pay for their retirement was taxable income to them. 

As I've talked to my clients over the years, they repeatedly say, “man, if my younger self had only known about this idea of tax diversification!” We talk about investment diversification, the old “don't put all your eggs in one basket” idea, but really, we don't learn about tax diversification. In a nutshell, it's just the idea that there's three kinds of taxable accounts. There's the tax me now, there's the tax me later, and then there's the tax me never.

Our tax code just incents us to save into the tax me later, which are the tax deferred accounts like our 401(k)s and IRAs, but there's this very intentional strategy that says, “Hey, that's not all bad, but let's not do that to the exclusion of all the others.” So, there's this idea that says there's a preferential order of saving when you're a younger professional earlier in your career. That's when you really want to front-end load your savings into the tax never bucket. For example, this would be saving into your Roth IRAs or Roth 401(k)s so that, yes, you're giving up the tax deduction, but you're younger and in lower tax brackets, so it's not as painful. This way, that tax never money, aka tax free money, has the longest time period to grow. Then, when you get later in your career, now you're in higher tax brackets that tax deduction becomes more valuable to you for saving into your 401(k)s.

Then, later in your career and when you’re in higher tax brackets, that's the time to start saving into the tax later bucket so that again, you're getting the tax deduction when you really need it later on. And, that money doesn't have as much time to compound and grow because you are saving it later in your career, so the bulk of your money is still in the tax never account, which is ideal.

For the tax now account, that's going to be things like bank accounts or your after-tax investment account. Of course, everybody needs some bank accounts or some rainy-day emergency fund money. But, even your after tax investment accounts can be tax-smart just based on what kind of investments you are choosing for those accounts, whether you're using municipal bond funds, tax managed mutual funds, etc. So, there are all sorts of ways that you can be intentional in your investing strategy to not just focus on what you’re investing in, but which kind of accounts you’re investing in to always create the lowest possible tax burden to you. Because, I mean, we all share the goal of paying taxes at the lowest rates possible.

My last parting thought is if you think taxes are going to be greater in the future, which, if I was a betting woman, I would think so, then that’s all the more reason to sock away into that tax never type of account. Again, those are Roth IRAs, Roth 401(k)s, health savings accounts, college 529 plans, cash value life insurance, etc., and these types of accounts are going to insulate you and protect you from future tax increases.

So again, while you're thinking about investment diversification, think about tax diversification too, because building wealth is great, but building tax-free wealth is really the name of the game.

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