The average investor isn’t aware of the fact that there is a huge difference in the total return of a standard stock investment versus a retirement investment.
Thankfully, the United States goverment has encouraged retirement savings by adding the benefit of tax efficiency both as it grows and either at the purchase or sale. In other words, you can either put pre-tax income into your retirement and postpone paying taxes until you retire, or you can put post-tax income in now, and never have to pay taxes again.
Despite the benefits of tax-efficient retirement investing, something that’s frequently forgotten when you invest for retirement is to actually consider the role taxes play and the effect they will have on the total return of your stocks. Keeping this in mind will help you make wise retirement investing decisions, both when you put the money in and when you take the money out.
You may have invested carefully in great stocks that performed well, and you may have hedged your 401(k). But what happens when you cash it in? Do you really know what taxes are going to do to you? If you’re like most people, the answer is no. Do you know, really well, exactly how much you’re going to need for retirement? Again, if you’re like most people, the best you can do is give a vague answer based on a guesstimate.
But the key to a successful retirement is knowing and understanding the relationship that your investments have to taxes. Here are some things to think about to maximize you money. First, calculate how much you’ll need for retirement:
- What kind of lifestyle you want and how much you’ll need annually to support it.
- How much your target number for your day of retirement should be.
- How long you’ll probably be retired.
- Where you’re going to live and whether you will own or rent your home.
- How to provide medical and other insurance for yourself and your family.
- How you’re going to spend the days, and what expenses are associated with that.
From these questions, you will have a realistic idea of how much you’ll need for retirement. Don’t forget to figure in the sale of your current house if you’re going to move, too; that can help you afford the lovely home in the Bahamas you’re set on. Then figure that you’re going to need about $25 in savings and investment for every $1 per year you need to live. This ensures you can live mostly on interest without touching your principal. You should probably also assume that your savings are the only income you will have; we don’t know what’s going to happen in this day of pension fund reneging and changing Social Security.
Once you have your numbers straight, you need to take a look at how taxes will cut into them. Do you have a tax-deferred pension vehicle, a 401(k) or an IRA? These are great for keeping your income taxes lower, and for using money from deferred taxes to build up your compound interest, but eventually you will have to pay the piper in the form of Uncle Sam.
In the case of the 401(k) and the Traditional IRA, your earnings are not taxed until you retire and start drawing the money, so it would be better if you were in a lower tax bracket during retirement. With a Roth IRA, you pay taxes before you put the money into retirement, and all your earnings are taken out tax free. This is the strategy to use if you plan to be in a higher tax bracket when you retire.
The cut you take from taxes would be easy to figure into your whole retirement plan – except that the tax rate is not predictable. It may be higher or lower than today’s; you just don’t know. This is where you need to start betting (or making educated guesses!). Do you think taxes will be higher or lower when you retire. Chances are, if it’s going to be ten years or more, and you are acquire wealth during that time, they’ll be higher. There is very little chance they’ll be lower. So take your current tax bracket, add about 1/3 of its amount to it, and figure that into your retirement numbers as the amount you’re probably going to be taxed. It’s an additional expense, but you have to plan for it.
But why, you might ask, should I use the tax deferred dollars if I’m just going to have to pay them eventually plus capital gains? Because the tax money in your account is free interest-drawing capital. This means that your money grows faster and goes to work harder. And because if you’re using a 401(k), your employer is probably matching at least a portion of your investments. Once you reach the top of the employee matching bracket, you might want to consider investing in a Roth IRA, which have better tax structuring for you when you retire and which also defer taxes.