The Deferral Trap
My wife follows Twitter and sent me the below attached piece from Bloomberg about 401(k)s. I did not believe the title at first, but the article does make some valid points about the changes in tax laws and the availability of low cost funds to the general public since 401(k)s were created in the late 1970s. The article’s conclusion, that employer 401(k) plans offer less benefits to most taxpayers than they did 30 years ago, is true.
Despite the article’s valid points, I think most middle-income people should take advantage of these plans, especially if your employer provides matching funds as this is free money to the employee that no one should pass up. However, for a different reason, I agree with the Twitter article in that I would be careful how much you put into these “tax-deferred” plans. I know the upfront tax deduction is great, but putting all your retirement funds into these plans may come back to haunt you. And I say this knowing that you are very likely going to be in a lower tax bracket in retirement than you are while working. The reason for this is, once you are retired, you will realize there are other things to consider when managing your retirement funds besides investment returns and minimizing taxes. I will explain below, but first, let me give you a real-world example of what can happen if you place most or all of your retirement funds in tax-deferred vehicles.
I have a friend who just finished building a new $500k house. He, of course, used funds that were outside his tax-deferred retirement funds to build his new home. As it turned out, the new home project cost about 15% more than he expected and he ended up using all the funds that were not in his tax-deferred retirement accounts to complete the project.
My friend was a high-income guy when working, so he has other sizeable retirement accounts, but these “other” funds are all in “tax-deferred” retirement plans (i.e., Traditional IRAs). I found this out because we were discussing buying gold. He told me he wants to buy gold bullion, but he has no available funds to do so (NOTE: you cannot take personal possession of gold bullion using IRA funds). He also told me his annual taxable Required Minimum Distributions (RMDs), which start in 5 years, will be huge. I suggested that he should start making big annual Roth IRA conversions before he turns 70 and starts collecting social security benefits. He told me he would like to, but he does not have enough money in non-traditional IRA accounts to even pay the taxes on the IRA Roth conversion amounts. Frankly, I was shocked that my friend got himself into this situation as he is a very smart guy.
Additionally, my friend wants to buy a new car for $40k, but, since all his remaining liquid funds are in tax-deferred accounts, he would have to take $55k out to pay $15k in state & Federal taxes on the $40k car purchase. I did not mention it to him, but if he truly has no other liquid funds, he will also have to pull out another $5k out of the IRA, to pay the tax on the $15k tax, and so forth. Unfortunately, my friend is experiencing what is informally known in the financial planning industry as, ”the deferral trap.”
My wife and I made a different plan for our retirement funds. About six years before we retired, we had about 70% of our retirement funds residing in taxable traditional IRAs. About that time, I read an article somewhere titled the same as this blog post describing a similar situation to my friend’s. Right then I decided we would make some big changes. The last 6 years of our working lives, despite being in a 32.5% combined tax bracket, we put 100% of our annual retirement funds into Roth IRAs and regular taxable accounts. By the time we retired we had reversed the ratio to 70% non-taxable retirement funds and just 30% in traditional IRA type accounts. This now gives us a lot more flexibility about how and when we want to spend our retirement funds. There are a couple of other benefits of this planning from 15 years ago. First, we now have non-taxable funds to live on so I can delay starting my social security benefits until age 70 increasing the benefit by 32%. Second, this delay in collecting social security has allowed us to make larger annual Roth IRA conversions. As a result, currently about 85% of our total retirement funds are non-taxable and only 15% are in taxable retirement accounts.
Some will say it is stupidity to forgo the larger tax break when working. If you are in one of the top 3 income tax brackets, then I would agree with you. But these higher income people have plenty of disposable income to save other funds outside of retirement accounts. For the rest of us, let me just say from experience, there are a lot more ways to pay taxes when you are still working. When you are retired, your options to pay income taxes are very limited. But, in my opinion, the real benefit from this approach is the flexibility you have with your retirement funds.
Before you retire, you will need to create different “buckets” for holding funds in short-term type investments. I do not mean different investment style buckets, but buckets that serve different purposes during your life. And these funds need to be liquid and non-taxable.
For example, we have an older home here in MD which, if we stay in it, will need some major upgrading. So, I have set aside one bucket of $120k for installing a new roof, new windows and upgrading our kitchen. This bucket also includes funds to buy a new car….presumably our last. This $120K is held in a “tax-free” Roth IRA and is invested in a short-term bond fund (currently paying 2%, but that will certainly change in a couple years). We have another $70K bucket of funds which reside in a couple Health Savings Accounts (HSAs). These funds are invested in short-term bank CDs. This bucket is in case we experience a health care shock that requires immediate funding or, for some reason, is not covered by Medicare. These funds also serve as the amount needed (in a decade or so) to fund the first 90 days (the deductible period) before our Long-Term Care policy starts paying benefits. Our particular needs determined our different buckets and their funding sizes.
Finally, there is one other thing to consider. I just do not see income taxes going anywhere but higher from here, and possibly much higher. So, if you are currently 50 years of age and plan to retire in 15 years, it is possible your tax rates could actually be higher in retirement than what you are paying now. Nobody knows what the future holds. But I would bet a lot of money that the tax rates we have now are the lowest they will ever be for anyone currently alive….and they are scheduled to expire on 31 December 2025.
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