How will my Retirement accounts be taxed? ROTH
Picking up from last week’s conversation surrounding pre-tax retirement accounts, today we will walk through the opposite of pre-tax accounts – ROTH accounts (after tax) – and we will touch on Health Savings Accounts (HSA’s), which technically are triple tax advantaged if certain criteria is met.
ROTH Accounts (ROTH IRA’s, ROTH 401ks & HSAs)
So, contributions to ROTHs are made with after-tax dollars, these contributions grow tax deferred and can be withdrawn 100% tax free as long as the ROTH has been open for 5 years and you are over age 59 ½. One note – you can always withdraw your contributions prior to 5 years, but the earnings cannot be withdrawn tax free and penalty free without satisfying both rules.
In addition, there are income phase out limits in order to contribute to ROTH IRAs, but these do not apply to ROTH 401ks.
Utilizing ROTH contributions can be a great idea when you expect to be in a higher marginal tax bracket in the future. For example, you are 30 years old and in the 22% marginal tax bracket, but given your career path, potential earnings, and lifestyle, you expect to be in the 32% tax bracket in retirement. Making ROTH contributions allows you to pay taxes today on the dollars contributed, and not have to worry about taxes down the road. In addition, ROTH accounts are not subject to Required Minimum Distribution (RMD) – which is when the government requires you to withdraw a specific amount from your pre-tax retirement accounts based on your age. As mentioned last week, this can create a tax bomb for many folks if not properly planned for.
Furthermore, as noted last week, I often find that clients tax situation and investment planning can benefit from having a balance of pre-tax and ROTH contributions. From a tax standpoint, this allows for flexibility and choice with eventual withdrawals as you can plan around years of lower income to take bigger distributions from pre-tax accounts (with the hope of paying lower tax than when you contributed) and withdraw from ROTHs in higher income years once RMD’s kick in, or if there is a big purchase planned.
Within the investments, this provides for additional flexibility with asset location – which is the concept of owning certain assets in specific account types based on the accounts tax treatment, but also the growth potential of the asset. Therefore, assets with high growth potential should be owned in ROTH, and assets with the lowest growth potential should be owned in pre-tax accounts since the withdrawals are 100% taxable. Lastly, assets that are the most tax advantaged (ETF’s, individual stocks, low dividend paying securities) should be held in a normal taxable account (brokerage account).
Health Savings Account (HSA) – Triple Tax Advantage If Used Properly!!
This additional account type can provide for choice outside of simply saving for retirement. Your eligibility to contribute to this type of account does depend on which healthcare plan you currently have – if you have a high deductible health insurance plan you should be eligible to contribute to an HSA – number wise you need a minimum annual deductible of $1,600 (single plan), $3,200 (family plan) and a maximum deductible and out-of-pocket expenses of $8,050 (single plan), $16,100 (family plan).
To summarize, an HSA is an account that lets you set aside monies on a pre-tax basis to pay for current or future qualified medical expenses. By doing so, you also receive a reduction in your taxable income by making this contribution. The current contribution limit in 2024 for a family plan is $8,300 and $4,150 for individuals. Moreover, for most plans, as long as you leave a few thousand dollars (depends on the specific plan rules) in the cash portion of the account, the remaining monies can be invested in the mutual fund options offered – very similar to your 401k or 403b plan investment options.
At this point I often have the conversation with my clients to determine if you withdraw these funds to pay for medical expenses today, or if you pay out of pocket and allow the invest portion to grow. Additionally, the monies built up in the account can be used to pay for Medicare premiums at age 65 – more specially Medicare Part B, Part D, Medicare Advantage Premium, deductibles, copays, and coinsurance! In some cases, you can also use these funds to pay for individual long term care insurance premiums up to a certain amount each year (amount varies depending on your age).
I personally think HSAs are often overlooked as a savings vehicle, so I typically encourage clients to at least understand the underlying pros and cons prior to make a decision. Aside from an HSA being triple tax advantaged - meaning that the money is contributed pre-tax (reduces taxable income), the monies that are invested grow tax-deferred, and the withdrawal of these funds are all tax-free as long as they are utilized for qualifying medical expenses.
Once you turn age 65 you can actually utilize this vehicle as a normal pre-tax retirement account - just like your Traditional IRA or 401k – however, the only thing to be aware of here is that the withdrawals are taxable if they are for general retirement purposes. Lastly, let’s say your HSA has been open for 10 years and you paid out of pocket for a medical procedure 5 years ago. Under current rules, you can go into your HSA and reimburse yourself for this expense tax-free (as long as you have your receipt to back this up)! As a note, you must have had your HSA open at the time of this procedure. Pretty cool.
In conclusion, I hope the past two blogs have provided a good overview of common retirement accounts, how they are taxed, and what goes into deciding how much to contribute to each type of account.
Next week we will dive deeper into asset location – what is it, how it compares to asset allocation, and how to implement it.
Thank you for reading!
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give tax or legal advice.