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Retirement Tax Diversification

After my last blog post, I received a couple of questions concerning the concept of tax diversification. In this post I will discuss this topic as it relates to one of the biggest tax mistakes many future retirees make in their financial planning. It is known as “The Deferral Trap.”

For most workers today the simplest vehicles available for retirement saving is an Individual Retirement Account (IRA) or an employer’s 401(k) plan. These IRS qualified accounts allow the worker to contribute funds to these accounts every year and deduct the contribution amount from their taxable income. The accounts are then allowed to grow for decades untaxed. At the age of 591/2 or later, when the worker is presumably retired, withdrawals are allowed from the accumulated funds. Income taxes are owed at the time of withdrawal.

These tax deferred retirement vehicles are useful on a couple of levels. In addition to the tax deduction, employers often match an employee’s contribution to their 401(k) plan up to a certain percentage of the worker’s annual income. This incentivizes workers to make retirement account contributions. Furthermore, there are financial penalties for early withdrawal. This makes it difficult for a worker to withdraw and spend this money which, I think, is a good feature of these accounts as the money should be dedicated for retirement. The accounts need to be left alone. Later when the worker is in his 60s and retired, withdrawals are made from these tax-deferred retirement accounts.

The Deferral Trap

Throughout the worker’s career, he/she has been enjoying the tax deductions that the retirement accounts allow. However, if all your retirement assets are in one of these IRS qualified tax-deferred retirement accounts and you have no liquid assets outside of these accounts, you have been caught in what is informally known in the financial planning industry as the “The Deferral Trap.”

If all your retirement income consists of an employer provided pension and the withdrawals from tax-deferred retirement accounts, 100% of your retirement income is taxable. You have no control over your annual tax bill. Furthermore, with current tax law this situation affects whether your social security benefits are taxable. How do you know if your social security benefits are taxable?

For a married couple you add one-half your social security benefit to your other retirement income. If the total is less than $32,000, your social security benefits will not be taxable, if this figure is greater than $32,000 but less than $44,000, 50% of your social security benefit is taxable. If this figure is over $44,000, 85% of your social security benefit is taxable. As you can see if all your other retirement income is taxable, it also affects how much of your social security benefit is taxed. This web page from the Social Security Administration (SSA) gives the detailed rules to determine taxability.

There is another important tax reason why you do not have all your liquid assets in tax deferred retirement accounts. If this is the case, every time you have a major capital expense such as a new roof on your house or buy a new car, you will have to pay taxes on the funds to buy these items. For example, let’s say you need to buy a new car for $20,000. If you must withdraw funds from your tax deferred retirement accounts to buy the car, and you are in a combined 25% tax bracket, you will have to withdraw $25,000 from your retirement accounts; $20,000 for the car purchase and another $5,000 to pay the income taxes on the $20,000 withdrawal to buy the car. If you do not have any liquid assets outside your tax deferred accounts to pay the $5,000 taxes, you will have to draw another $1,250 from your tax deferred accounts to pay the income taxes on the $5,000 tax withdrawal needed to pay for the $20,000 withdrawal. As you can see this can get into several cycles of withdrawals just to pay taxes. Needless to say this is not a very efficient way to use your retirement assets. As a side note here, it is a good idea to make as many capital upgrades to your home, cars, or other large physical assets as possible while working to avoid these large capital outlays in the early years of retirement.

Tax Diversification

Everyone should have a goal of tax diversification at retirement. But what can the average person (still working) do to achieve tax diversification down the road? Well, the only real way to avoid the deferral trap in retirement is to pay the taxes while you are working. Unfortunately, this means reducing your take home pay. Paying more taxes while you are still working and, presumably, in a higher tax bracket, may sound like a bad idea. However, no one knows what the tax rates will be in the future. It is possible that tax rates could be much higher in the future and the higher rates may be applied at much lower income levels than today. Achieving tax diversification in retirement is just another form of risk reduction for your retirement assets.

In 1997 Congress passed another retirement saving vehicle called the Roth IRA. This IRA works a little different from a traditional IRA. The Roth IRA allows the worker to make annual “after-tax” contributions to a Roth IRA. However, all contributions to a Roth IRA not only grow tax deferred, but they are withdrawn “Tax-free” after age 591/2. If you were willing to pay the taxes on all your IRA contributions (i.e., a Roth IRA) while working, you could retire and withdraw all funds from the IRA 100% tax free. However, there are annual contribution limits to a Roth IRA. In 2011 the limit is $5,000 per person (you must have at least $5,000 of earned income to contribute $5,000 to an IRA) and, if you are over 50 years old, you can contribute another $1,000 per year for a total of $6,000 per year.

There are also income limits to restrict high income people from contributing to Roth IRAs. The table below summarizes the income limits on Roth IRA contributions.

This Table shows at what income level your Roth IRA contribution is limited

I think the Roth IRA is a great tool for planning your retirement taxes. In 1998 my wife and I each started contributing $2,000 per year to our Roth IRAs. We have taken full advantage of this savings vehicle since then. In 2010 the new higher limits allowed us to contribute a combined total of $12,000. During this time period we were also maxing out our contributions to our employer 401(k) plans (up to $22,000 each per year plus corporate matching funds) as well. However up to 2006 our 401(k) funds were all pre-tax contributions, meaning they are taxable when withdrawn in retirement just like a traditional IRA. Even though we contributed the maximum to our Roth IRAs every year, our 401(k) contributions were much larger. As such by 2006 our retirement account assets were about 80% in accounts that will be taxable at withdrawal. I did not like this situation as we were being pushed more and more into the tax deferral trap. Every year we had less tax diversification in our retirement accounts.

Fortunately a tax law was passed in 2003 that allowed employers, starting in 2006, to offer what is called a “Roth 401(k).” This new 401(k) works the same way as the Roth IRA allowing after-tax contributions to your 401(k) account with tax free withdrawals in retirement. Since, in 2006, our retirement funds were heavily weighted toward taxable withdrawals, we changed our contributions to 100% Roth 401(k) accounts for the last 5 years of our working lives. This change combined with our annual $12,000 contributions to our Roth IRAs (yes you are allowed to do both), got our retirement account mix to just about 50% traditional IRAs and 50% Roth IRAs. We now have much better tax diversification.

I should point out that my wife and I did this even though we were in a 32.5% (combined Federal and state) tax bracket. Many people think it is better to get the tax break now as they believe they will be in a lower tax bracket in retirement. This may be true, but I think it is best to pay some of the taxes while you are still working. While working you have more options to pay the higher tax burden. When you are retired, your options for dealing with taxes are greatly reduced. And as I said previously tax diversification in retirement is another form of risk reduction to protect your assets.

If someone’s earned income puts them in one of the two highest federal tax brackets, currently 33% and 35% (plus any state taxes), I understand it is hard to give up a tax break that allows you to save $350 for a $1,000 contribution. Anyone in this income range probably should utilize all tax deferred retirement vehicles available to lower their current tax bill as much as possible. But people in this income range should be able to save significant amounts of funds in addition to maxing out all tax deferred retirement accounts available. This additional savings will provide them tax diversification by having significant assets outside of any retirement accounts.

If a worker cannot contribute to all retirement accounts, how should they prioritize their retirement account contributions? Assuming you have already set aside 3 to 6 months living expenses in a savings account for emergencies and you are not in the higher income tax brackets, this is how I would prioritize my retirement savings.

1. If you have an employer sponsored 401(k) plan with employer matching funds, I would contribute to this 401(k) the amount necessary to capture 100% of the employer’s matching funds. These matching funds are free money; you do not want to pass up this valuable employer benefit.
2. After capturing your employer’s matching funds, I would stop contributing to your employer 401(k) and, whatever funds you can afford, I would contribute as much as possible to your Roth IRA (assuming you do not hit the income limits for making Roth IRA contributions as indicated in the above table). If by chance your employer offers both a traditional and Roth 401(k) accounts, I would split my contributions equally between the two account types. If one account, for any reason, becomes much larger than the other, then adjust your future contributions to favor the account with the lower account balance.
3. If you are fortunate enough to be able max out your Roth IRA and can afford to contribute more to retirement accounts, you should open a Roth IRA for your spouse and contribute the max amount to their Roth IRA account. As long as you have enough earned income to cover both, a person can also contribute to their spouses Roth IRA even if the spouse has no earned income.
4. If, after maxing out your spouse’s Roth IRA, you are still able to contribute more retirement funds. I would return to your employer’s 401(k) and contribute the remaining amount allowed.
5. If, after doing all this, you still want to dedicate more funds to retirement, I would open a taxable brokerage account and begin “dollar cost averaging” monthly contributions into broad index stock funds. Alternately, you could just open a savings account to accumulate funds to purchase income producing real property for investment.

This summarizes the retirement account savings priority I would use while in the asset accumulation phase.

A few more general tips when making retirement account contributions:

• It is best to make monthly rather than annual contributions to any account as this allows you to take advantage of “Dollar Cost Averaging” (DCA). If you are not familiar with the concept of DCA, click here to get a simple explanation of this important concept.
• I have often written on this blog about the importance of maintaining a proper equity/fixed income allocation in your investments. Many people, however, make the mistake of maintaining this equity/fixed income allocation with their monthly retirement account contributions. To get the most benefit from DCA, your monthly contributions should be 100% equities added to the stock funds you have selected. The equity allocation discipline I talk about in other posts should be applied only to the funds already residing in your retirement accounts and not your contributions.
• When you change jobs, do not roll over your previous employer’s 401(k) assets into your new employer’s 401(k) plan. 401(k) plans are high cost vehicles with very limited investment choices. Roll over all previous employer 401(k) assets to an IRA operated by a low cost fund manager such as Vanguard, Fidelity, or Schwab.

Ok enough about boring taxes.

In my next blog post I will introduce you to what I think is the best model available on the Internet to run your own personal financial numbers. It is a great tool to see if your savings are on track to meet your retirement goals, or, conversely, how much annual income your retirement savings will safely support.

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