Are you missing the tax-free bucket?
You may plan to use a mix of assets to meet your retirement income needs but there are other more tax-efficient sources of supplemental retirement income that are often overlooked.
Assets Where You Pay Income Tax on Distributions
- 401(K) Plan
- Pension Plan
- Traditional IRA
Assets are usually held within a retirement plan where distributions are normally taxed at the Ordinary Income Tax Rate (max rate = 37%).
Assets Where You Pay Capital Gains Tax on Distributions
- Mutual Funds
- Real Estate
- Sale of a Business
Assets are usually held outside a retirement plan where earnings are normally taxed at the Capital Gains tax rate (max rate = 20%).
Assets That Are Tax-Free On Distributions
- Roth IRA
- Municipal Bond Interest
- Cash Value Life Insurance (when structured specifically)
Distributions are typically income tax-free.
Strategy In Action
A hypothetical case study
Meet Jack B. and Jill S. Both were small business owners in Las Vegas, Nevada for 25 years. Each of them accumulated $2.5 million dollars upon retirement and began to collect $100,000 from their retirement accounts every year. However, Jack and Jill allocated their investments into different tax “buckets”.
Jack decided to use the more traditional route by allocating 75% of his retirement money into his 401k at work and 25% of his money into real estate and stocks.
Jill on the other hand, decided to allocate 25% of her retirement money into her 401k, 25% into real estate and stocks, and 50% into a tax-free asset.
Although Jack and Jill each accumulated $2.5 million at retirement age, their retirement income became significantly different.
Jack’s effective tax rate was an astounding 31.25% which caused his $100k retirement income to be dwindled down to $68,750.
Jill’s effective tax rate was only 13.75% which allowed her take home $86,250 of her $100k retirement income! By simply allocating 50% of retirement funds into a tax-free asset, Jill was able to receive $17,500 more in retirement income!
The moral of the story? It pays to pay attention to which “buckets” you are funding during your working years.
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