Friday, August 22, 2014

When and How to Use Retirement Accounts

Really successful people do things that others do not do.  One of those things is use of retirement accounts in a powerful and purposeful way.  When and how should you use retirement accounts?

Retirement accounts are useful for two things.  One is to defer taxes and the other is to force you to keep that money set aside for retirement or pay a penalty.  All retirement accounts but ROTH IRAs can grow tax free until you take the money out at which time the entire amount you withdrawal is taxable income to you.  During the year you turn 70.5 years old you are required to take what are called Required Minimum Distributions.  So while you don't pay taxes on that income now the intent is for it to become taxable income to you at some time in the future.

When Should You Use Retirement Accounts

So contributions to your retirement account(s) are deductions for you on your tax return in the year the contribution is made (possibly until you file your tax return).  Reducing your taxable income this year is good right?  In a way, yes, because you reduced the amount you owe in taxes this year but you also just lost control of that money until you turn 59.5 years of age unless you pay a penalty (and yes there are some exceptions).

What is the big deal about not being able to access that money for a long time?  You need to realize that your money in retirement accounts is not really available to you in case of an unexpected emergency like a lost job.  Also, for the most part you cannot get at that money to fund your start-up business or other business investment opportunities.   The suggestion is that you have at least three if not six months of reserves on hand to cover your cost of living in the event of the unexpected.  In addition, really successful people keep a healthy amount of liquid funds that they can use to finance other investment opportunities.  So really you want to both contribute to your retirement account annually but also set money aside as reserves for a rainy and grow an investment account.  Most people focus only on contributing to the retirement account and not the other savings which in a way are more important.

One great reason for contributing to your retirement account is when you employer matches your contributions.  Then you should maximize your contributions if you can also put money into savings for your reserves and add to your investment account.

One of the biggest hindrances to saving and building up reserves and an investment account is your lifestyle.  It seems people value buying things and don't really understand the opportunity value of putting their money to work for them.  You see you should have money making you more money in addition to your own labor making money for you.  As I brought out in my previous post, that really successful people build an investment account to have money working for them and they are very aware of opportunities as a result of having that money available to invest.  It is a mindset that really successful people have.

So to answer the question of when to use retirement accounts, it should be after you already have three to six months of cost of living reserves in the bank and you should have a balance between your contributions to your retirement accounts and your investment accounts.  When your employer matches your retirement contributions you may want to have more proportionally set aside for this purpose but you still want to build up reserves and investments.  It is a little different when you can take advantage of the matching provision.

How Should You Use Retirement Accounts

You should use retirement accounts to defer taxes and build up money that you can use in retirement but will be subject to tax when you take it out.  Then in retirement you will want to use these funds from your retirement account until you reach the sum of your deductions and exemptions on your tax return because after that you will be paying taxes on that money.  At that point you can take your already taxed money out of your investment accounts if needed to live off of.  The only tax you will pay on that money is on the as yet untaxed gains.  If these gains are capital gains they may not even be subject to tax.  Currently (2014) dividends and capital gains are untaxed to you until your taxable income exceeds $36,900 for a single person and $73,800 for a married couple filing jointly.  So under the current law it would be very helpful for you to be able to pull from both retirement and investment accounts when you retire.  For more on taxes on gains and dividends from investment accounts see my previous post by clicking here.

ROTH IRAs can grow tax free and are typically tax free when you withdrawal money from them after you turn 59.5 years of age and they will be the subject of other upcoming posts.

As you can see this is a somewhat complicated area and it would help to consult with both a CPA and a financial adviser.

The CPA Superhero wants to help you to succeed in business, life, and in retirement.  While my main business is preparing tax returns, I also work with clients to setup accounting systems to start, manage and develop their business(es) and develop and implement a financial plan. Contact me using my information below to schedule a free introductory consultation up to a half hour. 

Jeff Haywood, CPA

The CPA Superhero

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My posts contain general information that does not fit every situation, they are not all inclusive, and as always for your tax situation everything "depends on facts and circumstances."  In addition, the information/IRS requirements are always subject to change.  So call me to talk about your specific facts and circumstances and what you want to accomplish.