Why Different Accounts Matter and Funding Your IRAs

by | Mar 31, 2023 | Blog

By Adam K. Wright, CFA®, CFP® 

If you’ve paid enough attention to people talking about investments, you’ve likely heard the phrase “Don’t put all your eggs in one basket.” It is the analogy we use to convey the importance of diversification. Then again, even if you know nothing about investments, you’ve probably heard that phrase! You simply don’t want to have all your money tied up in one specific company or even one sector of the economy, or even one asset class

Yet what you likely haven’t heard is that the same philosophy is true of your account types. That’s because different account types have different tax treatments, and when your savings are spread across different tax buckets, you gain the ability to generate more tax-efficient retirement income. In this article, we’ll go through five reasons that’s the case. At the end of the day, it is all about creating a flexible retirement plan and making sure your plan can thrive in a wide variety of situations.  

1. Different Account Types Have Different Tax Treatment

There are a number of different account types you can open, and each one has a unique tax treatment. We like to call these tax buckets. Download our handy one-pager. The four main tax buckets are: ordinary income, capital gain, tax-deferred, and tax-free. Here is how they work:

  • Your ordinary income is the default bucket, which counts income from Social Security and earned income from your work. When you receive this income, you have to pay ordinary income tax rates, which can be as high as 37%, before surcharges. That’s a rather unfavorable tax rate, and means Uncle Sam claims up to half your earnings! If possible, good proactive financial planning helps you avoid paying rates this high.
  • In your capital gain bucket, you will hold your investments in a joint account or individual brokerage account. For some, this may also be a revocable living trust too. Depending on the type of investment you own, as well as how long you hold it, you could pay capital gains tax rates, or qualified dividend rates, which come with preferential tax rates ranging from 0% to 20%.
  • In a tax-deferred account (like a traditional IRA or 401(k)), you receive a tax deduction when you contribute to the account and the money will grow tax-deferred, but you will owe taxes when you withdraw. This is a great tool to receive a tax deduction when you contribute, but you have to weigh the risks that taxes will be higher in the future. The vast majority of our retirement plans fall into this bucket. We don’t want it at $0, but we also don’t want these accounts to be our only retirement income source. If they are, you may get hit with a tax torpedo.
  • Finally, in a tax-free account (like a Roth IRA or Roth 401(k)), the money contributed will be taxed in the current year, but it will grow tax-free and you can distribute it tax-free in retirement. With good tax and retirement planning, this bucket can help you avoid getting killed in taxes in retirement. 

We are generally big fans of the Roth IRA, and even high-income earners who don’t qualify may be able to contribute to them through the backdoor method. If you don’t currently have much (or any) in tax-free-type accounts, we highly recommend you look into it. Many of the advantages of the Roth come with time. It is necessary to start early! 

2. Keep Balance Between Retirement and Investment Accounts

A retirement account (like your 401(k) or IRA) will have certain restrictions in terms of the maximum contribution, income eligibility, and may even limit your investment choices. A regular investment account, on the other hand, doesn’t have any of those sorts of restrictions. A regular investment account is the unsung hero of retirement planning. You can contribute as much as you want, and you usually have a vast array of investment options from which to choose. Finally, as long as you are smart with your taxes and the management of your account(s), you may be eligible for the lower, more favorable long-term capital gains tax when you eventually want the money. Many people in the investment world focus and encourage people to constantly fund their retirement accounts, but in our experience, too many people planning for retirement miss out on  the added flexibility and potential tax advantages of a regular investment account.

3. Using Different Accounts Allows You to Create Retirement Income More Tax-Efficiently

Another benefit to diversifying your account types is that when you get to retirement, it will give you options in terms of where to create your retirement income. For instance, if you have money in all four buckets (ordinary income, capital gains, tax-deferred, and tax-free), then with the help of your financial planner, you can determine how to create tax efficient retirement income. Multiple options give you flexibility to take a distribution from the most advantageous account in that particular year. But if you have all your money in one account type, you won’t have those options and you could end up paying a higher tax bill than you’d like (more on that in point 5).

4. Retirement Requires Planning Ahead 

Just as it’s key to save and invest for your future retirement years (and preferably decades) in advance, the same is true with diversifying your account types. While there are some strategies you can utilize to turbocharge your tax diversification, it’s often easier and more tax-efficient to do it slowly, over time. One key reason for that is because of the contribution limits retirement accounts set, which limits how much can be done per year, thereby increasing the importance to get a plan and start implementing it as soon as possible. 

Like everything that is good in the long term, diversifying accounts compounds in value over time. The more you can defer (or avoid!) taxes, the greater the value. Starting early—with a solid retirement plan—matters greatly. Oftentimes there is very little to do and very little value to extract if you call a financial planner for the first time on the eve of your retirement. 

5. Using Only One Account Can Create a Tax Torpedo

If you rely solely on one account type for your retirement savings (like a tax-deferred 401(k)), you may unwittingly expose yourself to the risk of a tax torpedo. What is that, exactly? Let’s say you have all your retirement money in tax-deferred accounts when you’re ready to retire. For instance, you diligently maxed out your 401(k) each and every year and at retirement it was a balance of $3,000,000. However, with the increasing amount of debt that the U.S. has, an aging population, and not enough people contributing to Social Security and Medicare via payroll taxes, our politicians decide that they need to raise taxes in order to meet all our obligations. Well, guess what? All your distributions from your tax-deferred account would be subject to these higher taxes. And since you haven’t diversified your account types, there’s only one way for you to get this money—by distributing it from your 401(k) and paying whatever tax rate the government requires. As you can imagine, any increase in taxes will offset what you’ll be able to spend in retirement. And if taxes increase too drastically, it could impact how much you can safely distribute, and if your investments will last the length of your retirement. Because of this potential risk, we want to review every option possible so we never get to this point in the future where we don’t have any options or flexibility with regards to taxes.

It is key to remember that Uncle Sam, the Tax Man, has a partial claim to your 401(k). He’s given you tax-deferred growth for decades, and in retirement those taxes come due. Without careful planning, your distributions can dramatically increase the cost of healthcare with IRMAA surcharges, push you into higher tax brackets, and leave you unprotected from changes in tax rates. 

Have You Diversified Your Account Types?

While the logistics and strategies are varied and depend on your unique circumstances, our main point is simple: We want you to be diversified, both with your investments as well as your account types. By planning ahead, and taking full advantage of your opportunities on a yearly basis, you can increase your tax flexibility and potentially lower what you’ll owe in taxes over your lifetime. 

Planning for taxes in retirement needs to happen in advance, sometimes 10 to 15 years before you want to retire. The value of good retirement planning compounds over time, and there is no better time to get started than today.

If you’d like to put together a tax-planning strategy, we’d love to help. You can schedule a complimentary phone call to get started and learn more about our services.

About Adam

Adam Wright is a CERTIFIED FINANCIAL PLANNER™ professional at Wright Associates, helping clients plan and prepare their investments to retire on their terms. If you’re serious about planning for your retirement and investing for your future, his annual process will help you make the right money choices today. Therefore, Adam and his team will proactively manage your accounts while communicating the progress of your financial plans. He believes the retirement advice you receive should be intentional and actionable.

Adam has a Bachelor of Science in Supply Chain and Information Systems from The Pennsylvania State University and a Master of Business Administration from University of Pittsburgh, Katz Graduate School of Business. He lives in Upper St. Clair with his wife and two children. When he’s not working, Adam enjoys the outdoors (fly fishing), reading, and taking long runs while listening to a favorite podcast. He’s also currently encouraging himself to take up golf. To learn more about Adam, connect with him on LinkedIn.


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