Have you ever found yourself thinking where are the best places to save money for retirement? Is it better to save to a tax-deferred account like a 401(k), tax-free account like a Roth IRA, or taxable account? I get it. It can be confusing, but my response is always the same: it depends on your tax bracket. That usually raises a skeptical eyebrow because most think, what does my tax bracket have to do with where I decide to save for retirement? Well actually quite a bit. That's because various retirement savings accounts have different tax treatments that impact not how much you'll pay in taxes, but ultimately how much is available for retirement. While there are no hard and fast rules to determine the best places to save for retirement, there are a few guidelines you can use to select the best retirement savings strategy to increase retirement savings and have more income available for retirement.
Here are 4 guidelines to consider when determining the best places to save for retirement:
Guideline #1: Aim for tax diversification. Prioritize a savings strategy with a mixture of taxable, tax-deferred, and tax-exempt savings. Ultimately you want a higher amount of tax-exempt savings relative to taxable and tax-deferred savings to hedge against possible future tax rate increases as withdrawals from tax-exempt accounts are tax free.
Guideline #2: Pay taxes when in a lower tax bracket. Prioritize saving to or converting tax-deferred assets to tax-exempt assets like Roth IRAs and Roth 401(k)s when current tax rates are lower than future tax rates. Doing so will defer current taxes, and qualified withdrawals from tax-exempt accounts will be tax free as well.
Guideline #3: Defer taxes when in a high tax bracket. Prioritize saving to tax-deferred accounts such as employer qualified saving plans like 401(k)s and 403(b)s that provide a tax deduction and defer taxes until withdrawal.
Guideline #4: Convert taxes when in a lower tax bracket. Prioritize converting tax-deferred savings like IRAs, 401(k)s and 403(b) accounts to tax-exempt accounts like Roth IRAs when current tax rates are lower than what's expected in the future. Paying the conversion tax at lower rates will decrease taxes and increase after-tax income.
One of my financial planning manifestos is: control what you can and plan for what you can't. While you cannot control the tax rates themselves, you can control how much of your money is subject to those tax rates by making smart decisions on where and when you save to the various types of retirement accounts. This starts with knowing your tax bracket and understanding how your savings are taxed, so you can lower your taxes and optimize after-tax income. With these guidelines in hand, you'll be in a better position to make more tax-friendly decisions about the best places to save for retirement and keep more of your money for retirement. Remember a penny saved is a penny earned. When it comes to having enough income for retirement, it doesn't matter how you've earned it.