4 tax moves to consider early in your career

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Consider these tax tips
These tactics could potentially help you save on your taxes now while putting you in a better position to work toward your long-term investing goals.
From the Merrill Edge Minute e-newsletter.

Key points

  • Due to the power of compounding, small tax savings invested while you're young could produce greater results than larger amounts invested later on
  • Spreading your investment assets across different account types could provide for more tax-efficient withdrawals in the future
  • Matching different types of investments to different types of accounts can increase tax efficiency
Thinking strategically about federal taxes early in your career has the potential to save you money now, but it could also help you lay the groundwork for achieving important long-term financial goals. And the sooner you begin, the better.
Because of the power of compounding, money you save on your taxes and invest while you're young has far more potential to grow than money you invest later in life. So the younger you are when you start investing, the longer the money has to grow. And even though retirement may seem very far away, investing a small dollar amount in a retirement account over a long period of time can have a greater impact on investment results than investing a larger dollar amount for a shorter period of time. The chart below shows how.
Starting early can help you save more for retirement
Source: Merrill Lynch Wealth Management, Retirement Strategies group. This example is hypothetical and does not represent the performance of a particular investment. Results will vary. Actual investing includes fees and other expenses that may result in lower returns than this hypothetical example.
As you can see, even modest amounts of spare cash freed up now through tax savings and invested for the future could result in better total returns later on. Even if you're unable to contribute more to a retirement account right now, remember to continually look for opportunities to invest more so you can give your investments as much time to grow as possible.
Consult with a tax advisor and consider these four strategies.

1. Make the most of your paycheck

Early in your career it can be tough to find unneeded cash for investing to take advantage of the power of long-term compounding. One way to find additional money is to recalculate the amount of taxes withheld from your paycheckrecalculate the amount of taxes withheld from your paycheck. If you're expecting a significant refund this year, consider reducing your withholdings to increase your take-home pay. After all, when you get a tax refund, it's as if you've made an interest-free loan to the government. Then set up direct deposit to put the extra money directly into an investment account.
You could also consider earmarking part of any salary increase or bonus for retirement investing. This can be a fairly painless way to invest because it won't reduce your take-home pay.

2. Contribute to tax-qualified accounts

Of course your eligible contributions to a 401(k) (or other employer-sponsored plan) or an IRA could lessen your tax burden now by reducing your taxable income. In addition, because any growth in a 401(k) or an IRA is generally tax-deferred, the power of compounding over time is further enhanced. So maximizing your contributions while you're young is a smart move, especially if your employer matches part of those contributions.1
Current income tax-reduction opportunities include:
  • Traditional IRA contributions, which are generally tax deductible depending on your tax filing status, if:
    • You don't exceed certain income limits, or
    • You and your spouse don't participate in an employer-sponsored retirement plan, such as a 401(k)
  • Traditional 401(k) contributions, which are made on a pre-tax basis and reduce your current taxable income by deferring taxation until retirement
Future income-tax reduction opportunities include:
  • Traditional IRAs and traditional 401(k)s, which offer not only pre-tax contributions or potential tax deductions, but tax-deferred investment growth potential
  • Roth IRAs and Roth 401(k)s, in which contributions are not tax-deductible (though subject to certain conditions), but offer the potential for tax-free growth plus the added bonus of federally tax-free (and possibly state-tax-free) withdrawals after age 59½ (assuming certain conditions are met)
Contribution limits for investors younger than age 50
Aim to increase your retirement contributions up to the maximum allowed in your 401(k), IRA or other retirement plans.
Maximum contributions for 2017
Traditional2 or Roth IRAs $5,500
401(k)s $18,000
For 2017, the contribution deadline for IRAs is 4/15/18 and for 401(k)s is 12/31/17.

3. Spread your assets among different account types

Different types of investment accounts are treated differently for tax purposes. Having a variety of account types to choose from means you can mix and match withdrawal sources in the future, potentially reducing federal taxes. This could also help increase your flexibility since you don't know whether your tax rates in retirement will be higher or lower than they are now.
One advantage to spreading your investments among different account types now, early in your career, is that the assets in each type of account have the potential to grow over the years. Some account types you might consider:
  • Non-retirement investment accounts. Any growth will be subject to tax only upon the sale of securities held in this type of account, and any gain recognized on such sale generally will be subject to the lower long-term capital gain tax rate.
  • 401(k) & IRA accounts. Tax treatment will vary depending on whether they are:
    • Traditional 401(k)s and traditional IRAs. Your account's earnings will be tax-deferred, and generally withdrawals in retirement will be taxed at your then-current federal tax rate.
    • Roth 401(k)s and Roth IRAs. Although contributions are made with after-tax dollars, your account's earnings will be tax-free and, after age 59½, if certain holding period requirements are satisfied, withdrawals are federally tax-free (and potentially state-tax-free).
When considering a Roth IRA, bear in mind that later in your career your "modified adjusted gross income" may exceed limits for Roth contributions and you would no longer be eligible to contribute. So, it may be worth thinking about contributing to a Roth IRA early on while you still may qualify to do so.
If you already have more than one traditional IRA and want to diversify your account types, you might consider is a Roth IRA conversion right for you? Converting all—or part—of one of those traditional IRAs to a Roth IRA could be beneficial. But remember that at the time of the conversion you'll need to pay ordinary income taxes on the amount you convert to the extent that the funds have not been previously taxed as income. So it could be advantageous to do this early in your career when you're probably earning less and your tax rate is lower, rather than waiting until later, when you could be earning more and paying taxes at a higher rate.

The future benefits of spreading your assets across account types

To understand the potential benefit of different account types, consider these guidelines.
  • Prior to age 59½, if you need to draw from your investment accounts, you may want to draw from non-retirement accounts because there is no early-withdrawal tax
  • Starting at age 59½, your strategy for tapping your investment accounts might follow this sequence:
    1. Consider drawing first from non-retirement accounts in which any gain recognized on the sale of securities in those accounts may be subject to the lower long-term capital gain tax rate
    2. Next, you may want to begin tapping your Roth 401(k)s and Roth IRAs. You won't owe taxes on distributions from these account types if certain holding period requirements are satisfied.
    3. If you're not yet 70½, save withdrawals from traditional IRAs and 401(k)s for last. Postponing withdrawals from these accounts allows the growth of these assets to remain tax-deferred for as long as possible.
    Note: Depending on your circumstances, the order you choose for tapping your investment accounts may be different than the sequence outlined above.
  • Once you reach age 70½, you may be required to take required minimum distributions (RMDs) from any traditional 401(k)s and IRAs you have. At that time, you will be subject to income tax on your RMD withdrawals. Consider taking your RMD first, and if you need additional funds, then draw from other accounts, as suggested above.

4. Match investments with the right account type

It also makes a difference where you hold particular kinds of investments. Consider taking full advantage of tax-efficient investments by holding them in accounts with tax treatments that complement that type of investment. This is an important consideration for younger investors, because even small differences can add up and compound over time. Consider these possibilities:
  • Investments that regularly generate taxable income, such as taxable bonds or stock funds with high turnover, may be better held in tax-deferred accounts—traditional IRAs or other retirement plan accounts, for instance—to defer any applicable taxes.
  • Investments that limit tax burdens, such as tax-managed mutual funds, exchanged-traded funds, and individual securities (including municipal bonds) are better suited for taxable accounts.
Keep in mind, decisions about where to hold various securities should be consistent with your overall financial strategy.
These ideas for tax-efficient investing shouldn't supersede your existing investment strategy, but considering these moves and discussing them with a tax advisor could be beneficial. They might help you save on federal taxes now and in the future, while allowing you to increase your retirement savings for potential long-term benefit. Particularly if you start early, tax-efficient investing might provide significant help as you pursue your financial goals.
Next steps

1 Taxes may be due upon withdrawal, depending on account type.

2A Traditional IRA also offers tax deductible contributions, if you are eligible.

Diversification does not ensure a profit or protect against loss in declining markets.

Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.