Tax-Free Bucket
Money invested in this bucket has two major advantages over any other bucket when it comes to growing your wealth. First, the interest gained in this bucket is allowed to grow tax free—this is huge. Seeing what a significant advantage this is, the government seeks to limit your contributions to this bucket. For example, you are limited to contributions of $6,000/year in a Roth IRA. This ensures that the bulk of your money will likely grow in environments subject to taxation.
The second great advantage is that distributions in retirement from this bucket do not count towards taxable income. For example, you may have social security and 401k distributions which are both taxed, but any surplus you receive from a Roth IRA, Life Insurance Retirement Plan (LIRP), or annuity isn’t counted toward your income. For the best understanding of this advantage, it’s best to see what happens when this bucket is neglected compared to when it’s used in conjunction with income from the tax deferred bucket and social security income in retirement.
In August of 2021, the average retired worker received $1,558.54 each month through Social Security. That puts the total annual Social Security income for that recipient at $18,702.48. Let’s take a look at the possible tax outcomes for an unmarried, retired worker who needs at least $50,000 annually to pay bills and survive when he supplements his income with 410k and/or LIRP distributions. We’ll use 2021 tax brackets to factor the taxes and assume no deductions in order to keep the examples straightforward.
Using the same circumstances, let’s say the retiree would rather live on $100,000/year, a much more comfortable retirement. Here are a few possible outcomes.*Minimum required distribution
*Minimum required distribution
What should be clear in both examples is that relying too heavily on your 401k will result in more taxes and the depletion of your 401k balance a lot more quickly. If we look at the first example in the first chart and assume a $1 million balance in this person’s 401k with consistent 2% gains in his 401k annually, his 401k will be depleted in 26 years. Assuming he retires at 67, he will have enough income to last him until age 93. However, $50,000/year in income doesn’t provide very much in retirement. If we run the same scenario with $100,000 in net income/year, his 401k will be depleted in 11 years at the age of 78. The last thing you want in retirement is to be worried you’ll live too long. Add in the concern that a 401k is unlikely to make consistent gains year after year, factor in a couple dips in the market, and your longevity becomes an even greater risk.
In addition to lowering your tax liability, some of these tax-free financial vehicles are immune to market downturns, allowing you to more aggressively grow your wealth. To truly diversify for retirement, finding out more about these financial vehicles is your natural next step and Real Life Solutions is here to help. Book your free consultation today for an assessment of your current wealth and growth opportunities.