Benjamin Franklin said there were only two things certain in life: death and taxes.
And while you can’t avoid taxes, you can choose when you want to pay them when it comes to certain accounts and savings.
To explain how the growth in your investments is taxed, consider that there are three different tax buckets: “tax me now,” “tax me later,” and “tax me never.”
We want to focus specifically on how the growth in your accounts is taxed, because you don’t put money into an investment for it just to stay level. You want your money to continue to grow.
The growth on your Thrift Savings Plan (TSP) and other investments will either be taxed now, taxed later, or even not taxed at all!
The Three Buckets
The first bucket is the “tax me now” bucket, or what we refer to as taxable money. As you continue to invest, you’re taxed along the way.
The second bucket is the “tax me later” bucket, which is probably what you have in your TSP account. That’s called “tax deferred.” On accounts in this bucket, you know you’re going to pay taxes, you’re just choosing to pay them later.
The third bucket is the “tax me never” bucket, which of course, sounds great. Remember, we’re only talking about the growth on accounts, not the principal. This is our tax-free bucket.
The “Tax Me Now” Bucket
Let’s break down each of these buckets more clearly:
In the “tax me now” bucket are accounts that you probably use on a regular basis: your savings account, your checking account, and the interest that grows in each of those accounts. Also, money markets, CDs, bonds, and normal mutual funds that are not in an IRA. The growth in these accounts is taxed each year. You need to fund these accounts with after-tax money, so you don’t get any tax advantage in the beginning. In fact, you’re not given a tax advantage at all in some of these accounts.
You’ll know that you have growth in a taxable account if each year you get a 1099. That’s the tax form that tells you what the growth is in your account and what you will need to claim. You claim that money as income on your taxes. While it’s great to know that you have, say, a mutual fund that made substantial gains that year, you’ll need to pay taxes in that year on the gain. Despite this drawback, it’s still better than spending all of your money throughout the year and not having anything to show for it.
The “Tax Me Later” Bucket
The second bucket is the “tax me later” bucket or tax deferred. In this bucket are accounts like a traditional IRA, a traditional 401(k), a traditional 403(b), or a traditional Thrift Savings Plan. These accounts are funded with pre-tax money, meaning that you get to contribute to these accounts without paying tax on that money right now. You get an immediate tax advantage and do not need to claim that contribution as income in the current year. This is great, because it feels good to not pay taxes.
When we’re thinking about tax deferred, we know we get that immediate tax advantage, but the tax trains will come in later. And we won’t really know what the taxes due are going to look like then. We want to be sure to be in a lower bracket at that point to get the advantage of not having to pay a lot of taxes later.
The “Tax Me Never” Bucket
As a last step, let’s talk about the “tax me never” bucket, or the tax-free bucket. In this bucket are accounts like a Roth IRA, a Roth 401(k), or Roth 403(b), or a Roth TSP. Other accounts you might be familiar with include the Coverdell Education Savings Account, the 529 College Plans, muni bonds, and life insurance proceeds. You do pay tax when you contribute to those accounts initially. These funds are contributed to with after tax money, meaning you need to claim the contribution that you’re making to these accounts as income in the current year.
Where the tax-free scenario comes in is how the growth is taxed later. We’ve taken care of the taxes on the principal, that’s the contribution that you made, but later the growth will also be tax free.
Consider this if you have all of your money in the first two buckets, either in the taxable bucket or the tax deferred bucket, which would be like your savings account (in bucket one) or traditional TSP (in bucket two). This would mean that in retirement, you won’t have any choices to maximize the opportunities to minimize your tax obligations in retirement. So consider putting at least some of your money in the third bucket.
The Roth TSP
As an example of an account that is in the “tax me never” bucket, consider the Roth TSP.
When your money goes into the Roth, you pay the tax today on that principal that you’re using to fund the Roth. When that account grows and you go to take the money out, both the principal and the growth will be tax-free, as long as you meet the normal IRS rules. All of the money you take out is tax-free. Many federal employees and retirees don’t realize that there’s tax-free growth in the account, which can make the Roth so attractive.
Which bucket is right for you?
The best way to divide your assets based on your tax status will vary for each person. As with so many financial planning topics, there is ultimately no single “right” answer for how to allocate your savings into these three buckets. What I can say is that you should have some percentage in each. This will allow you greater flexibility when producing income in retirement and offer you greater opportunities to use different financial planning strategies.
This is also a conversation you’ll want to have with a financial advisor, who can help you navigate which buckets are right for you. To find a local qualified financial professional in the ProFeds network, click here.