There are three key strategies for a successful retirement plan: Proactive Accumulation, Smart Investment Strategy, and Tax-Efficient Distribution. Each one builds off the others and together they create a powerful blend of what is needed to pursue financial independence. Let’s examine these essential elements of the retirement trifecta.
Having a proactive accumulation strategy is the first element of the trifecta. You don’t need $10,000 or even $100,000 to become an investor. We have helped many clients invest with less than $1,000 to start. Accumulating wealth doesn’t happen overnight. For most of us it will take years to accumulate enough assets to achieve financial independence. Financial independence means having a portfolio that generates the income you need for your unique lifestyle without having to work. Once you obtain financial independence the time to retire is up to you.
During the accumulation stage it is important to be proactive. In addition to having the discipline to invest each and every month, it is important to have a variety of tax diversified accounts. This is often overlooked but essential since our current low tax rate environment will most likely change in the future. Generally, there are three different ways accounts are taxed. We like to think of them as buckets. The first bucket contains taxable accounts. This usually includes investments like stocks, Exchange Traded Funds (ETFs), or low-turnover mutual funds. This account is funded with after tax dollars. In this type of account, you will pay taxes on dividends and interest but not on the capital gains until you sell the asset. It can be a very efficient way to build wealth and escape the majority of taxes until you decide to sell. If you use this type of account for long term needs, it is important to select tax-efficient investments to reduce the tax exposure.
The second bucket contains tax-deferred accounts. These are by far the most popular and include retirement accounts like your 401k, Traditional IRA, 403b, SIMPLE, SEP and other pretax accounts. The money you put into these accounts escape current income taxes and grows tax-deferred until you take the money out in retirement. When you withdraw the funds, 100% of what you take out (original contributions and the earnings) is taxable at the income tax rates in effect at that time.
The third bucket contains tax-free accounts. All Roth accounts fall into this category. A Roth is funded with after tax dollars, and it grows tax free as long as you follow the distribution rules. There are income limits to funding a Roth so please check with a qualified financial advisor or CPA before you invest.
In the accumulation stage we often see that most investors have all their assets in the tax-deferred bucket. The problem with that is that if tax rates go up, they will have no option but to pay higher taxes to access their money. Therefore, it is critical to fund accounts in all three buckets. This will provide you with control and distribution options when you retire.
Having a smart investment strategy is the second element of the trifecta. In the beginning of the accumulation stage, the strategy is to invest primarily in equities, allowing your assets to grow over time and build wealth. As your assets grow and retirement nears, it is important to modify the strategy and diversify your assets to include fixed income investments. However, we want your assets to last a lifetime and possibly leave a lasting legacy to your heirs, so maintaining exposure to equities should be part of your investment strategy.
Having a tax-efficient distribution strategy is the last element of the retirement trifecta. When you decide you want to retire, it is time to look at the income available and the tax impact of drawing from the assets you have accumulated so far. First, you must assess your expenses, and then your income sources other than your retirement assets. For most people this includes their social security income, and possibly a pension or income from other sources like real estate. If you need additional income, then you will need to access your retirement assets. The amount you withdraw, and its tax liability, will help determine where to draw your income from. For example, if you are in the 12% tax bracket or lower, you may want to consider using accounts in your tax deferred bucket as the main source. If you max out the 12% bracket and more funds are required, then consider using accounts in your other accumulation buckets to meet your income needs. Please see our tax guide here .
All of us need the retirement trifecta to build a successful retirement plan. However, the details in your retirement trifecta will be unique. Working with a qualified financial advisor can help guide you along the path of accumulation, ensure you have the right mix of smart investments, and tailor a tax-efficient distribution plan that is in line with your goals.
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