Retirement accounts can be categorized into three separate buckets to better understand the tax implications on your money. In our last blog, we discussed the tax treatment of investments held in Bucket 1 or the "Tax Me Now" Bucket. In this blog, we will explore Bucket 2, the "Tax Me Later" Bucket.
Inside Bucket 2: Tax Me Later
As the name infers, gains realized in this bucket do not create any taxable event in the current calendar year, and instead are “deferred” to when distributions are made from accounts held in this “bucket”. The vast majority of Americans have the bulk of their retirement savings in this second bucket, as a result of work place retirement plans sponsored by their employers. This bucket includes accounts such as:
- 401(k) plans
- 403(b) plans
- Section 457 (Deferred Compensation Plans)
- Traditional IRAs
Let’s take a look at an example. If you were to put $10,000 a year into one of your retirement accounts, such as a 401(k), this reduces your taxable income by $10,000. Let’s say you made $100,000 and invested it in this bucket. This means the IRS is only going to tax you on $90,000 because you’re taking a tax deduction on that money. This doesn’t mean you’re avoiding taxes. It means when you withdraw money from these accounts down the road, you’ll pay taxes on it then.
Capital Gains vs. Ordinary Income Tax
The advantage of Bucket 2 is that the contributions to these accounts are typically tax deductible, which means the income tax paid each year would be applied to a lower income. The individual’s income is reduced by the amount deferred, and as result, their total income taxes paid for the year would be reduced. The investments grow “tax-deferred”, In other words, taxes are only incurred at the time funds are actually dispersed from the account as opposed to when the investment is sold within the account. However, unlike distributions from Bucket 1 that can be subject to capital gains tax, distributions from bucket 2 are taxed at ordinary income tax rates. Further, these accounts have restrictions on how much an individual can contribute and when they can access the funds without penalty. The investment choices may also be limited to only those offered in the respective plan.
Like other bucket strategies that we have discussed in the Taxable Bucket blog, limitations and guidelines for contributions to Bucket 2 also apply. A conversation should be had with a knowledgeable financial advisor concerning this and other strategies. Schedule a call with an experienced advisor at Archstone Financial today.
This information is provided by Archstone Financial for your education only. Neither Voya nor its representatives offer tax or legal advice. Please consult your tax or legal advisor before making a tax-related investment/ insurance decision.