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When you’re saving for retirement, where you put your money will affect the taxes you pay in the future.
Chad Kennedy, partner and financial planner at Lighthouse Financial, said the goal of tax planning isn’t to reduce your tax burden one year, but to reduce the amount of tax you’ll pay over your lifetime.
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“Using different types of investment accounts can significantly reduce your tax burden over your lifetime,” he says. “There are three types of investment accounts: pre-tax, after-tax and tax-free. Ideally, you should strive to accumulate assets balanced across all types, so you can enjoy the tax benefits of each. Most importantly, you’ll have control over how you’ll be taxed in retirement.”
Here’s some expert advice on how to combine retirement accounts to avoid future taxes.
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What to consider when mixing retirement accounts
“If your goal is to reduce your tax burden, you should focus on pre-tax contributions to your employer’s plan, whether that’s a 401(k)/403(b)/457 or other employer-based plan,” said Joseph Favorito, CFP and founder and managing partner at Landmark Wealth Management LLC.
“Contributions to these plans not only reduce your adjusted gross income (AGI) and lower your tax liability, but in some cases they can reduce your AGI enough to allow you to make additional contributions to other accounts, such as a Roth IRA.”
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How to Combine Roth and Traditional IRAs to Maximize Tax Benefits
“IRA contributions are limited to a total of $7,000 per year ($8,000 if you’re over 50),” Favorito says. “You can also split that and contribute a portion to each. Whether you use both or one of them depends on your tax situation for the year.”
“For example, if you participate in an employer plan such as a 401(k), you most likely won’t qualify for the tax deduction of a traditional IRA, so a Roth may be more attractive. It’s a case-by-case basis.”
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How a 401(k) account can help you with a tax-efficient retirement strategy
“A 401(k) is essential for lowering your AGI, which allows you to make Roth contributions and helps with other tax planning,” Favorito explains. “The income limits for Roth contributions are based on your AGI.”
How to use a Health Savings Account to save on taxes
Favorito said HSA accounts function as a hybrid between a traditional IRA and a Roth IRA when used for medical expenses.
“The contributions are deductible and the money grows tax-free,” he said, “but if you don’t need the money for medical expenses, once you reach age 59 1/2, the money accumulated is treated as a traditional IRA for tax purposes. Withdrawals are taxable if not used for medical expenses, but you still get to deduct your contributions by reducing your AGI each year you contribute.”
“For people who are maxed out in their employer’s 401(k) plan, an HSA account can be an additional savings vehicle. It’s even better if you can put the money towards medical expenses. But if you don’t need it for medical expenses, it can be valuable as an additional savings vehicle.”
Benefits of incorporating a taxable brokerage account
“If you’re planning on retiring early, traditional retirement plans can be difficult to use because of rules that state you can only make penalty-free withdrawals after age 59 1/2,” Favorito said. “There are ways around this, such as the 72T withdrawal strategy, but there are limitations.”
“By saving a set amount in a taxable investment account, you can use it as an income source to bridge the gap until penalty-free IRA/401(k) withdrawals. Efficient management of taxable brokerage accounts can minimize your tax liability over the years through proper tax-loss capture techniques.”
How to balance contributions between tax-deferred and taxable accounts
Favorito said the balance of contributions to tax-deferred and taxable accounts depends largely on current tax rates and liquidity needs.
“Taxable accounts offer a greater advantage in inheritance upon death due to increased basis rules,” he explained, “but tax-deferred accounts allow you to accumulate more assets while you’re younger.”
“It’s smart to make the most of your employer’s plan, especially if your employer is making contributions. But if you have other goals beyond retirement, like buying a home or a car, it’s often wise to save outside of taxable accounts.”
Common mistakes when managing multiple retirement accounts
Favorito said one common mistake is working multiple jobs or changing employers mid-year.
“This could lead to overcontributions because the two payroll departments don’t know how much is being contributed elsewhere,” he explained.
Favorito noted that another common mistake is investment allocation.
“Spreading yourself across many accounts often results in inconsistent investment allocations,” he says. “It’s important to look at your investments as a whole, not just each account.”
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This article originally appeared on GOBankingRates.com: I’m a Financial Planner: How to Combine Retirement Accounts to Avoid Future Taxes