Where do I invest for retirement? This is a common question for all investors, but the longer you have until retirement, the more important it is.
You may not realize it, but you are really asking two questions with this simple question:
- What type of vehicle do I use to invest for retirement?
- What do I actually invest in within that vehicle?
The first question – What type of vehicle do I use to invest? – addresses the tax advantages within the vehicle.
You’ve probably heard of a Roth IRA. That’s a type of retirement vehicle and would be a potential answer to our first question.
But, you can’t invest in a Roth IRA
You can, however, contribute money to a Roth IRA. That may sound like semantics, but it’s a really important distinction you need to understand.
You see the first question you’re asking (whether you know it or not) and the first choice you need to make is – what type of vehicle should you contribute to in order to minimize taxes and therefore maximize your after-tax wealth?
You might think that isn’t an important question and that it’s still semantics, but let me show you a quick example.
Let’s say you’re 35 and you invest $1,000/month for the next 30 years in 2 different types of vehicles:
- The first is a taxable investment vehicle (like a brokerage account) in which you pay taxes on capital gains, interest, and dividends as you go. I don’t want to get too technical, but we’ll assume you are taxed at the current qualified dividend/long-term capital gains rate of 15% and that your returns are fully taxed each year.
- The second is a tax-free vehicle, like a Roth IRA, in which you pay no taxes by waiting until you’re 65 to withdrawal the money.
We’ll say you invest in a stock mutual fund that does well and averages 8% a year over the 30 year period.
At the end of the 30 years when you’re 65 and ready to retire, with the taxable investment vehicle, you’ll have accumulated $1,172,903. Not too bad, right? Sort of makes you want to invest for retirement, doesn’t it?
But with the tax-free vehicle, you’ll end up with $1,490,359. That’s a difference of over $300,000 and over 25% more wealth!
That $300,000 is simply money that you paid to the federal government (we aren’t even considering state or local taxes here) because of the type of vehicle you chose for retirement.
Now, do you see why the first question – What type of vehicle do I use to invest – is so important?
Good, I’m glad you do. Because too many investors overlook or don’t understand this first decision.
Now, let’s look at your options for retirement vehicles.
There are basically 3 broad types of retirement investment vehicles:
Vehicle 1: Tax-Deductible
This is the more common type of retirement vehicle and includes: Traditional IRA, 401(k), 403b, 457a, Simple IRA or 401(k), SEP IRA, Profit Sharing Plan, and several others.
They all work like this: 1) you contribute pre-tax money today, 2) you get to deduct that amount in the current tax year, 3) the taxes from capital gains, dividends, and interest are tax-deferred, and 4) you pay taxes when you withdraw the money in retirement.
Tax-Deductible vehicles are great for high-income earners who are subject to high marginal tax rates today. This allows them immediate relief from taxes and no ongoing investment taxes.
However, all of the money will be taxable at ordinary income tax rates when you withdraw the money in retirement. If income tax rates are higher in the future, this could mean a big bite out of your retirement savings.
Vehicle 2: Tax-Free
This list includes: Roth IRA and Roth 401(k).
They work like this: 1) you contribute after-tax money today, 2) you receive no tax benefit in the current year, 3) the taxes from capital gains, dividends, and interest are tax-deferred as you earn them, and 4) you pay no taxes when you withdraw the money in retirement.
Tax-Free vehicles are ideal in my opinion. You don’t get a tax deduction today, but let’s be honest, you would simply spend that tax savings on your lifestyle anyway. It’s not like you would save 15% in a Traditional 401(k), but only 10% if you chose a Roth 401(k) because of the taxes. You’re going to save the same percentage no matter which vehicle you choose.
So, it basically works as a forced, additional savings. Instead of getting the tax savings from the Tax-Deductible retirement vehicle to spend, you save it. And when you’re 65, you’ll have that money tax free!
Not only that, but the money you withdraw from your Tax-Free vehicle in retirement won’t be counted as taxable income. That means it won’t affect the tax rate you pay on other income, like social security, pensions, consulting income, or other work.
The money you withdraw from a Tax-Deductible vehicle will be counted as taxable income so you’ll potentially be in a much higher tax bracket if you go that route.
Vehicle 3: Taxable
This list includes: Brokerage account, Deferred Comp Plan, Restricted Stock Plan, Stock Option Plan, Employee Stock Purchase Plan (ESPP), Money Market, Savings, CD, and others.
These technically aren’t retirement vehicles, but many investors use them as such because they are benefits offered by employers or because they have maxed out their ability to use other tax-advantaged retirement vehicles.
They work like this: 1) you contribute after-tax money today, 2) you receive no tax benefit in the current year, 3) the taxes from capital gains, dividends, and interest are taxable every year, and 4) you pay no taxes when you withdraw the money in retirement, however, sales from investments to fund withdrawals will usually trigger capital gains taxes every year in retirement.
Taxable vehicles are often ignored or overlooked when creating a retirement savings strategy, but they do offer several benefits:
- You can access your money whenever you want without penalties. Note, this can also be a disadvantage because funds set aside for retirement get spent on lifestyle!
- Long term capital gains (investments held over 1 year) and qualified dividends are currently taxed at lower rates (15% for most taxpayers) than ordinary income taxes.
- You have flexibility in when you pay taxes
As we saw earlier, the decision on which retirement vehicle to choose can have a major impact on your wealth. Over $300,000 or 25% more wealth in our example.
Make sure you take the time to make the best decision for you and your family and consult a professional if you aren’t confident in making the right choice yourself.