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These tactics potentially could help you save on your taxes now while putting you in a better position to work toward your long-term investing goals.
Thinking strategically about federal taxes early in your career has the potential to save you money now, and it also could help you lay the groundwork for achieving important long-term financial goals. And the sooner you begin, the better.
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
Because of the power of compounding, any tax savings that can be invested while you're young has far more potential to grow than money you invest later in life. So the younger you are when you start investing, the longer the money has to grow. And even though retirement may seem very far away, investing a small dollar amount in a retirement account over a long period of time can have a greater impact on investment results than investing a larger dollar amount for a shorter period of time. The chart below shows how.
Starting to invest early on — even just a small amount — may help you in retirement
By starting to put away money earlier, a 25-year-old investing $200 per month ($2,400/year) accumulates more assets by age 65 than if he or she had started to invest $300 per month ($3,600/year) at age 35 — despite investing less each period.
This assumes an average annual return of 7.8%.
Source: Chief Investment Office. This example is hypothetical and does not represent the performance of a particular investment. Results will vary. Actual investing includes fees and other expenses that may result in lower returns than this hypothetical example.
As you can see, even modest amounts of spare cash freed up now through tax savings and invested for the future could result in better total returns later on. Even if you're unable to contribute more to a retirement account right now, remember to continually look for opportunities to invest more so you can give your investments as much time to grow as possible.
Consult with a tax advisor and consider these four strategies.
1. Make the most of your paycheck
Early in your career it can be tough to find unneeded cash for investing to take advantage of the power of long-term compounding. One way to find additional money is to recalculate the amount of taxes withheld from your paycheck. If you're expecting a significant refund this year, consider reducing your withholdings to increase your take-home pay. After all, when you get a tax refund, it's as if you've made an interest-free loan to the government. Set up direct deposit to put the extra money directly into an investment account.
You also could consider earmarking part of any salary increase or bonus for retirement investing.
2. Contribute to tax-qualified accounts
Of course, any traditional 401(k) contributions to a 401(k) account (or other employer-sponsored retirement plan account) or deductible contributions to an IRA could lessen your tax burden now by reducing your taxable income. In addition, because any growth in a 401(k) account or an IRA is generally tax deferred, the power of compounding over time is further enhanced. So maximizing your contributions while you're young is a smart move, especially if your employer matches part of those contributions.Footnote1
Current income tax reduction opportunities include:
- Traditional IRA contributions, which are subject to annual contribution limits and generally are tax deductible if you don't exceed certain modified adjusted gross income (MAGI) limits. The amount of the limits depends on your tax filing status and whether you or your spouse participate in an employer-sponsored retirement plan, such as a 401(k) plan.
- Traditional 401(k) contributions, which are subject to annual contribution limits, are made on a pre-tax basis and reduce your current taxable income by deferring taxation until retirement. Your employer may match at least a portion of your contribution, so you should consider contributing enough to take advantage of that benefit.
Future income tax reduction opportunities include:
- Traditional IRAs and traditional 401(k) accounts, which offer not only pre-tax contributions or potential tax deductions but also tax-deferred investment growth potential
- Roth IRAs and Roth 401(k) accounts, in which contributions are not tax deductible (though contributions are subject to certain conditions) but that offer tax-deferred growth plus the potential for federal income tax-free (and possibly state tax-free) withdrawals if the requirements for a "qualified distribution"Footnote2 are met. View the most current 401(k) and IRA contribution limits (PDF).
3. Spread your assets among different account types
Different types of investment accounts are treated differently for tax purposes. Having a variety of account types to choose from means you can mix and match withdrawal sources in the future, potentially reducing federal taxes. This also could help increase your flexibility since you don't know whether your tax rates in retirement will be higher or lower than they are now.
Some account types you might consider:
- Non-retirement investment accounts. Any growth will be subject to tax only upon the sale of securities held in this type of account, and any gain recognized on such sale generally will be subject to the lower long-term capital gain tax rate if the assets are held for more than one year before sale.
- 401(k) accounts and IRAs. Tax treatment will vary depending on whether they are:
- Traditional 401(k) accounts and traditional IRAs. Your account's earnings will be tax deferred, and generally, withdrawals in retirement will be taxed at your then-current federal tax rate.
- Roth 401(k) accounts and Roth IRAs. Although contributions are made with after-tax dollars, your account's earnings will be tax deferred, and if the requirements for a "qualified distribution"Footnote2 are met, withdrawals are federal income tax-free (and potentially state tax-free).
When considering a Roth IRA, bear in mind that later in your career your MAGI may exceed the limits for Roth IRA contributions, and you would no longer be eligible to contribute. So, it may be worth thinking about contributing to a Roth IRA early on while you still may qualify to do so.
If you already have more than one traditional IRA and want to diversify your account types, you might consider whether a Roth IRA conversion is right for you. Converting all — or part — of one of those traditional IRAs to a Roth IRA could be beneficial. But remember that the amount of pre-tax assets converted in a Roth IRA conversion are included in your taxable income for the year the conversion occurs.Footnote3 So it could be advantageous to do this early in your career when you're probably earning less and your tax rate is lower — rather than waiting until later — when you could be earning more and paying taxes at a higher rate. Another reason to convert earlier rather than later is if you convert the balance when it's had less time to grow, you'd be paying taxes on a smaller amount.
The future benefits of spreading your assets across account types
To understand the potential benefit of different account types, consider these guidelines.
- Prior to age 59½, if you need to draw from your investment accounts, you may want to draw from non-retirement accounts because there is no early-withdrawal tax. If you withdraw from a retirement account prior to that age, you may be subject to a 10% additional federal income tax unless an exception applies.
- Starting at age 59½, your strategy for tapping your investment accounts might follow this sequence:
- Consider drawing first from non-retirement accounts in which any gain recognized on the sale of securities in those accounts may be subject to the lower long-term capital gains tax rate
- Next, you may want to begin tapping your Roth 401(k) accounts or Roth IRAs. You generally won't owe federal income taxes on distributions from these account types if you meet the requirements for a qualified distribution, which generally means that you have reached age 59½ and five years have passed since the first day of the year of your first Roth contribution or Roth conversion if earlier.
- If you are not yet subject to required minimum distributions (RMDs), consider saving withdrawals from traditional IRAs and 401(k) accounts for last. Postponing withdrawals from these accounts allows the growth of these assets to remain tax deferred for as long as possible.
- Note: Depending on your circ*mstances, the order you choose for tapping your investment accounts may be different from the sequence outlined above.
Individuals are not required to take RMDs from traditional IRAs, traditional and Roth 401(k) accounts, and similar retirement plans until age 73 for individuals who turn 73 after December 31, 2022. Prior to January 1, 2023, the required beginning age was 72 for individuals who turned 72 between January 1, 2020 and December 31, 2022. You may defer your first RMD until April 1 in the year after you turn 73, but then you're required to take two distributions in that year. Note that the additional income from that second distribution could put you in a higher tax bracket and has the potential to substantially increase your tax bill.
Subsequent annual distributions are required by the end of each calendar year. If you don't take the full amount of these annual distributions within the required time frame, you'll incur an additional tax of 25% of the difference between what you received and the required amount you should have withdrawn subject to further reduction to 10% if the error is corrected within a two-year period.
However, if you continue to work and you own 5% or less of the business sponsoring the plan, the plan may allow you to delay taking distributions from the 401(k) or other employer-sponsored retirement plan until the year you retire. However, you'll still need to start RMDs from all traditional IRAs according to the normal schedule. You will be subject to income tax on your RMD withdrawals from your traditional 401(k) account and traditional IRAs you have, but any RMDs taken from your Roth 401(k) account would not be subject to income tax provided you satisfied the qualified distribution rules.Footnote4 Consider taking your RMD from your traditional or Roth 401(k) account or traditional IRA first, and if you need additional funds, then draw from other accounts as suggested above.
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4. Match investments with the right account type
It also makes a difference where you hold particular kinds of investments. Consider taking full advantage of tax-efficient investments by holding them in accounts with tax treatments that complement that type of investment. This is an important consideration for younger investors because even small differences can add up and compound over time. Consider these possibilities:
- Investments that regularly generate taxable income, such as taxable bonds or stock funds with high turnover, may be better held in tax-deferred accounts — traditional IRAs or other retirement plan accounts, for instance — to defer any applicable taxes
- Investments that limit tax burdens, such as tax-managed mutual funds, exchange-traded funds and individual securities (including municipal bonds) are better suited for taxable accounts
Keep in mind, decisions about where to hold various securities should be consistent with your overall financial strategy.
These ideas for potentially tax-efficient investing shouldn't supersede your existing investment strategy, but considering these moves and discussing them with your tax advisor could be beneficial. They might help you save on federal taxes now and in the future, while allowing you to increase your retirement savings for potential long-term benefit. Particularly if you start early, tax-efficient investing might provide significant help as you pursue your financial goals.
Next steps
- Try our Retirement Account Selector Tool to find out which accounts you're eligible for and potential tax advantages
- Read more about both traditional and Roth IRAs
- Estimate the federal income tax you want withheld from your paycheck
Footnote1 Taxes may be due upon withdrawal, depending on account type.
Footnote2 A "qualified distribution" is one that is taken at least five years after the first day of the year of your initial Roth contribution or Roth conversion if earlier and after you have reached age 59½ or become disabled or deceased. If you take a non-qualified withdrawal from your Roth 401(k) account or Roth IRA, any investment earnings on the Roth contributions are subject to regular income taxes, and you may be subject to a 10% additional federal tax unless an exception applies. State income tax laws vary; consult a tax professional to determine how your state treats distributions from Roth 401(k) accounts or Roth IRAs.
Footnote3 Roth IRA conversions are generally exempt from the additional 10% federal tax on early withdrawals. However, if you are under age 59½ at the time of the conversion, a 10% additional federal tax may apply if any converted assets are distributed within five years of the first day of the year in which the conversion occurred.
Footnote4 Alternatively, you could roll over your Roth 401(k) account balance into a Roth IRA, which is not subject to the RMD requirements during your lifetime.
Diversification does not ensure a profit or protect against loss in declining markets.
Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
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