Let’s consider the following scenario of two individuals looking to buy similarly priced dream homes. One was going to deplete their pre-tax retirement savings and the other was going to sell their appreciated non-retirement assets. Since they each had enough money, they both should be affected equally, right? Not really. They’re not equal since the tax treatment for each is much different. The profit from the sale of an appreciated asset (i.e., stock or mutual fund) that isn’t in a retirement account is taxed at the capital gains rate, but the sale of an asset in a retirement account is taxed at the regular income tax rate. Although both were cashing in assets of similar value, the net result was quite different.
Here is the problem with using your qualified pre-tax retirement accounts to buy your retirement home: Every dollar that comes out of a qualified account is taxable in the year withdrawn. If you take $500,000 out of your pre-tax retirement account (i.e., 401(k), 403(b), Thrift Savings Plan, Traditional IRA) you will owe at least $200,000 in federal taxes plus any state taxes depending on where you live. It may launch you into a higher tax bracket for that year and trigger more taxes on other household income.
Pre-tax retirement accounts are primarily a means of creating an income stream, not for major purchases. Yet, I see this mistake often. That is because the majority of Americans have their assets held inside pre-tax retirement accounts. These accounts have been funded over time as money is contributed from their paychecks, escaping current taxes. As retirement approaches, these accounts represent a considerable part of their net worth. Now, they are often eager to move to their ideal retirement destination and either buy or build their dream home. After all, here is a significant sum of money just waiting to be put to good use. Sound familiar?
To prevent this from happening we encourage our clients to invest in a tax diversified manner. What I mean by that is to have several different types of accounts that are taxed in different ways. For example, if you qualify, a Roth IRA is a great account to fund. The Roth IRA is an individual account that you pay into during your working years with after-tax dollars. The benefit of the Roth IRA is that the withdrawals are usually tax-free in retirement.
Another way to build wealth for the future is utilizing non-retirement accounts. These accounts are funded with after-tax dollars and minimally taxed until the investment is sold. Let’s take stock shares for example. If you invest in an individual asset like a stock, you can purchase that in a non-retirement investment account. If you purchase a stock for $10,000 and sell it 10 years later for $20,000, you will realize a capital gain of $10,000 in the year that you sell it. Currently, the capital gains tax rates are lower than ordinary income tax rates. Today, if you are in the 10% or 12% income tax bracket (see tax bracket chart here: www.financialfreedomwmg.com/resources) the capital gains tax rate is 0% – ZERO!
When it comes time to get their dream home, we encourage clients to liquidate assets from their non-retirement accounts that will generate capital gains and avoid taking considerable funds from their pre-tax retirement accounts. If using pre-tax retirement funds is your only option, consider spreading out the distributions over time. One idea is to secure a shorter-term mortgage and take annual distributions equal to the payments. This would spread out the withdrawals over a longer term and possibly not skyrocket you to the highest tax bracket. A qualified financial advisor can partner with you to create a tailored solution that is best for your unique situation. We want what we want, so it is important to get you that dream home, pay less in taxes, and not drain your hard-earned retirement accounts.
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