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Tax Bucket Strategies

Updated: Jan 23

By Michael Mooney, MBA, CFP, Financial Advisor

Is it possible to save TOO much for retirement? The answer is surprisingly yes – sort of!

When saving for retirement, many employers offer some sort of tax-deferred retirement plan such as a 401(K), 403(B), or SIMPLE IRA. Often, these plans have an attractive employer match for contributions that are made by the employee. Employees benefit by contributing to the plan, as they would be eligible to receive the company match and they can defer taxes on that income until they make withdrawals at retirement.

However, there are sometimes small drawbacks to investing a workplace retirement plan. Most of these have to do with flexibility. For one, many plans make it difficult to make withdrawals from the plan prior to retirement or separation from service. For some companies, in-service withdrawals are not allowed; other companies only allow withdrawals under certain circumstances. Additionally, even if you are able to withdraw money from your retirement plan, you could be subject to income taxes and early withdrawal penalties of up to 25%. Thus, an employee that is in a 24% Federal Tax Bracket and 4% State Tax Bracket could be subject to over 50% in taxes/fees by the IRS for making a withdrawal prior to turning 59 ½ years old!

Most often, it makes sense to contribute to your workplace retirement plan AT LEAST up to the point of receiving the maximum match contribution. For instance, if your employer matches your 401(k) contributions dollar-for-dollar up to 3%, you should consider to at least look to save 3% into your plan. However, anything above that amount will depend on your future cash needs and tax situation.

As an alternative to additional retirement savings, a good strategy to consider, is to contribute to a taxable brokerage account. Unlike a tax-deferred workplace retirement account, there is no tax advantage or deduction for contributing to this account, which is a negative. However, on the positive side, this type of account offers full flexibility for withdrawals. Brokerage accounts are taxed on the gains only; For example, if you add $10,000 to your account and invest it fully, you should only be taxed on any realized gains above $10,000. There are no tax penalties for early withdrawals, and the funds are able to be withdrawn immediately. Should you have investment goals prior to retirement (i.e. buying a house, a second house, travel, etc.), investing in a brokerage account is likely going to be the best way of reaching those goals.

That being said, investing is certainly not a ‘one size fits all’ situation. Specifically, if an investor already has sufficient assets in their taxable bucket, and/or if they are in a high tax bracket, doing a maximum contribution into your 401K likely makes the most sense; This would help to defer (and possibly save) on taxes. Separately, another investor may benefit most by Roth IRA/401K contributions due to an increasing income.

Additionally, there are other considerations to be made as well; Most retirement plan contributions (i.e. 401K) can only be made through payroll deduction. Thus, it is important to plan ahead, as employees are not able to make a ‘lump sum’ contribution at the end of the year when they have more clarity on their income needs.

It is important to review your goals with your Financial Advisor and see if you may benefit by shifting some of your excess retirement contributions into a brokerage account, or if it makes sense to increase your contributions. In either case, you are saving towards your goals and your future!

Wells Fargo Advisors Financial Network is not a legal or tax advisor. Any discussion of taxes represents general information and is not intended to be, nor should it be construed to be, legal or tax advice. Tax laws or regulations are subject to change at any time and can have a substantial impact on an actual client situation. Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of the author and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.



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