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Retirement Planning & Taxes: New Questions
By JLP | February 25, 2008
Tax diversity has become a more common discussion among personal finance experts in recent years. This is due not only to the plethora of tax-free, tax-advantaged, and taxable investment options that people have today, but also to the uncertainty of our future tax system.
This is a topic I haven’t thought much about, because the answer has always seemed obvious. I am young and in a low tax bracket; I also intend for my income to rise over the course of my life, even through retirement. I also happen to believe Congress will eventually be forced to increase tax brackets accross the board if we’re going to keep piling on the entitlement promises(which it seems inevitable that we will). Because of all this I really don’t think my tax bracket will ever be lower than it currently is.
So because I qualify for a Roth IRA contribution and am offered a Roth 401k at work, my simple retirement solution has been to take advantage of as much tax-free savings as I can. Seems like the right call, no?
Well, I just read an article that has made me think seriously about other options for the first time. Protecting Your Retirement No Matter Who’s President. It’s short and to the point; I recommend checking it out.
The author advises taking a “three-pronged” approach to maximizing your investments (i.e. minimizing taxes).
“First, stash at least enough in your 401(k) to get the full employer match. Use the account to hold your portfolio’s bonds. The interest will be taxed as ordinary income anyway — and the 401(k) will allow you to defer the bill.
“Next, if you’re eligible, fund a Roth IRA. The Roth won’t give you an initial tax deduction, but all withdrawals should be tax-free.
“Finally, if you have additional money to save, buy stock-index funds or tax-managed stock funds in your taxable account. These funds should generate modest annual tax bills, and when you sell, the realized gain will be dunned at the capital-gains rate.
This advice is far from new, except for the last bit. Rather than going back and fully funding a 401k, the suggestion is to invest in regular old taxable accounts (albiet with tax-friendly index funds). I’d never considered that being taxed later at the capital gains rate might be more favorable than being taxed later at your future ordinary income rate.
But I have a Roth 401k, not a Traditional one. So I guess the question for me is, do I think being taxed later at the future capital gains rate will be better than being taxed now at my current income tax rate? The answer should tell me whether to continue to invest in my Roth 401k (after getting the match) or choose taxable index funds.
I think that for young people like me the decades of tax free growth combined with not being taxed at all on the withdrawals in retirement is a situation hard to beat. Then again, it’s also kind of reassuring to be able to justify having accessible, if taxable, investments in case I encounter a serious emergency or other investing opportunity before I hit 60.
Consider the author’s final quote:
What’s the advantage of all this? If income-tax rates rise, that could cut into the value of your 401(k) withdrawals. If capital-gains rates climb, it will hurt your taxable account. And if the income-tax system is ever replaced with a national sales tax, the Roth will lose its luster. In other words, you’ve spread your tax risk — and thus you should be in good shape, no matter what Congress does.
Geez. I hadn’t even though of that…
More from Meg at The World of Wealth
Topics: 401(k), Index Funds, Retirement Planning, Roth 401(k), Roth IRA | 10 Comments »
February 25th, 2008 at 2:18 pm
Thanks. This is good advice.
February 25th, 2008 at 5:16 pm
I wish people would do the math on how much ordinary income taxes need to rise before an regular investment taxable account would be more beneficial than a 401(k) contribution (30% to 50%).
This is the problem with some financial advice. It sounds good in theory, yet the author needs to check the math to understand the probability for the advice to be beneficial.
The reason for this is that regular investment account is taxed twice (once when you are paid and again on earnings) where 401(k) is only taxed once on withdrawl. Thus, on a simplified analysis, the tax on 401(k) plan needs to increase by 15% capital gains rate / 28% current ordinary tax rate for it to be beneficial (note, this is simplified calculation and ignores original contribution).
Please read http://www.myfinancialawareness.com/Topics%20Financial/Power%20of%20401(k)%20and%20IRAs.htm to see the math behind the numbers (using more complete examples).
Plus, if you put your money in a retirement plan, it is protected from bankruptcy and I believe from eligibility for your children’s college financial aid.
February 25th, 2008 at 5:26 pm
Very good points, Pete. Thanks for the link. My problem of course is not only that I don’t know how to calculate and compare all those variables – but that even if I did, my personal variables are nothing more than guesstimates at this point anyway.
I just remind myself that the single most important factor is simply how much you put away in the first place, regardless of where you decide to stash it.
February 25th, 2008 at 7:39 pm
Agree with Pete. Putting money into accounts like a 401k makes the most sense. That author doesn’t take a few things into consideration, among them (regardless of the tax efficiency of the funds in your NEW taxable account) are taxes due on dividends, as well as, the problems created by making it easy for people to tap into these funds.
I contend one of the beautiful things about retirement accounts (because of the restrictions and penalties) are they keep people from themselves.
Retirement accounts tend to perform better in the long run because people leave them alone, because they know they can’t get at them. Another reason I think these new 401K debit cards are a horrible idea (save that for another day)
February 26th, 2008 at 8:17 am
Agree with the comments above. There are merits to tax diversification between tax-deferred and tax-free but they will beat saving in a taxable account because
a. tax rates would have to rise significantly in order to make it not that way (and who’s to say that capital gains rates won’t increase by even more given their current historical lows)
b. automatic savings in a retirement plan actually means money goes into an account instead of planning on saving “what’s left”
c. you can’t get at the money without significant pain, which is a great disincentive from you buying a car with your Roth money.
Meg, you can invest in almost any normal “investment opportunity” within a Roth or retirement plan as well. Don’t have to necessarily have the money in a taxable account.
February 26th, 2008 at 10:43 am
I agree with all of you, especially as Beyond P to P points out that I can make most any type of investment (real estate ventures, etc) through an IRA anyway. Plus you can always withdraw contributions without penalty or tax consequences in case of true emergency.
I’m not going to abandon my Roth IRA or 401k anytime soon. I mean tax free is tax free, and these types of accounts probably won’t be around forever anyway. Though when I’m no longer elligible for a Roth IRA (which I hope and assume will happen eventually), I will certainly begin investing in a Traditional IRA-or add some Traditional tax-deferred savings to my 401k. I already have much more in taxable index funds than in either type of retirement account, so maximizing tax free and/or tax deferred savings is the best choice for me in any event.
Thanks for all the comments!
February 26th, 2008 at 11:47 am
Thank you so much for the advice that you gave today. It was truly helpful. Being at the point of retirement, I was worried when I realized that I didn’t prepare for it. I never thought the day would come when I would have to think about this part of my life but it all came easy when my friend recommended a self-motivational CD tape that is truly helpful. Its the Retiring Right Freeway Guide. It was fun and easy to listen to. I definitely recommend it to anyone who is even thinking of retirement.
February 26th, 2008 at 5:18 pm
“The reason for this is that regular investment account is taxed twice (once when you are paid and again on earnings) where 401(k) is only taxed once on withdrawl. ”
There is a flaw in your math. What you are talking about isn’t really double taxation but the smaller compounded gains because for some reason you assume taxing all of your capital gains every year. But the taxes on capital gains are payable when you sell the stocks/funds. Sure some mutual funds have capital gain distributions, but these are gains realized from selling stock within the fund (which an index fund shouldn’t do that often) not from stocks growth.
Obviously you need to choose tax-efficient mutual funds for your taxable portfolio; you can also use ETFs which are traded like stock so you only have to report gains when you sell. If you buy individual stocks, you only pay gains when you sell the stock, not every year.
In an ideal situation, if you buy tax-efficient index funds or ETFs, you are only taxed once on your base income and once on the gains.
Having said that, I do agree with fully funding retirement funds (based on what one can afford), by the way, simply because of tax benefits now (and possible smaller rate in retirement). But in terms of which part of one’s total retirement and non-retirement assets to allocate to stocks and bonds, it does make sense to keep higher percentage of stocks in non-retirement assets than in retirement assets.
February 28th, 2008 at 9:12 am
Even with a flat tax, regulations can be written that would credit Roth IRA withdrawals for tax purposes.
March 14th, 2008 at 10:20 am
I recently opened a checkbook control IRA and glad that I contacted a company by the name Asset Exchange Strategies that really took time to explain and direct me on what is the best direction to take on investing my IRA for future investments.