Handling Finances

For the past year, as I graduated, got a job and got married, my finances have been quite chaotic. I paid off my student debts and started saving for long-term goals like retirement. I have started investing with a general goal to have a diversified portfolio, but until now I haven’t had time to sit down and plan it in detail.

First of all, I am diversifying my paying of taxes on my retirement savings. There are a number of tax-advantaged accounts that allow you to reduce the impact of taxes on retirement savings, but they generally fall into one of two catagories. “Traditional” 401(k)s and IRAs allow saving before taxes but charge taxes on any withdrawls. Roth IRAs, and the new Roth 401(k)s allow saving after taxes, but charge no taxes on withdrawl. With the traditional accounts, you pay taxes at retirement, and with the Roth accounts, you pay taxes now. If tax rates were constant, there would be very little advantage to one over the other but it’s pretty safe to assume that tax rates will not be constant!

Given that there will be more people retiring than entering the workforce for the next decade or two, I fully expect taxes to rise out of necessity, but since it will be a full four decades before I retire, I really have no way to predict what taxes will look like in my retirement. Further, it’s important to take tax brackets into consideration as well as tax rates. I only started my job in September, so I only earned a quarter of my yearly salary. Because my income was so low, I will be in a low tax bracket and I made sure to take advantage of this opportunity by investing the maximum in a Roth IRA. As my career progresses, and my income grows, I will be bumped into higher tax brackets making my 401(k) more attractive since it allows me to reduce my taxable income now so I can pay taxes later when I’m retired and my income/tax bracket is lower.

There will be times throughout my career that I find my tax rate is lower so I choose to invest in the Roth IRA and pay taxes now, and there will be times when I find my tax rate is higher so I choose to invest more in the 401(k) and pay taxes later. However, the key, in my opinion, is that investing in both types of accounts gives me a very basic level of tax diversification. When I retire, I will have more control over my tax burden and my retirement savings is subject to less risk due to changing taxes.