It’s been said the only certainties in life are death and taxes, to which Will Rogers famously quipped, “death doesn’t get worse every time Congress meets.”
Continue Reading Below
Life is full of surprises but your retirement should not be one of them.
Do you think that taxes will be higher or lower in the future? Tax diversification can help counter the ever-changing tax environment and provide flexibility in retirement. Tax diversification refers to placing your money in accounts with differing tax treatments.
There are three general tax categories of accounts: taxable, tax deferred, and tax-free. You can either defer for a year, even years, or pay the tax now and never again. The key difference between taxable and tax-free resides in when taxes are paid.
1. Taxable accounts – Growth in these accounts typically results in taxes in a given year, as all income is subject to taxes annually, whether it is received or reinvested. One key benefit of the taxable account is withdrawals, which can occur at any time without a tax penalty.
2. Tax deferred – These are typically referred to as retirement accounts, such as Individual Retirement Accounts, usually IRAs and 401(k) plans. They are specifically designed for retirement spending and have certain age restrictions and penalties for early withdrawals (most commonly before age 59 ½). In exchange for these restrictions, retirement accounts are allowed to grow tax deferred, meaning an individual gets a tax deduction now but must pay the taxes later.
3. Tax free – There are 3 places you can put your money and receive tax-free retirement income. A Roth retirement account, municipal bonds and maximum funded life insurance. Placing money in 401(k)s and IRAs provides you with a tax deduction now. Contributing to tax-free accounts provides you with tax-free income in retirement. Each delivers benefits that could prove to be more valuable depending on future tax rates.
The BIG question is this: where do you think taxes will be in the future? Let’s take a look at the facts:
- Can we really get rid of Social Security when it is the only source of income for nearly 1/3 of seniors?
- The national debt is how many double-digit TRILLONS of dollars? Who is going to lend us more money? How are we going to pay it back?
- With the baby boomers hitting retirement age, how is the US government going to pay for the exploding costs of Medicare and Medicaid?
Almost all of my clients believe taxes will be much higher in the future. If the majority of your retirement account is in traditional IRAs/401(k) accounts and you are able to forgo the current tax deduction, consider shifting your contributions to Roth accounts, municipal bonds and maximum funded life insurance. One of the best books I have ever read is Tax-Free Retirement by Patrick Kelly. He does an amazing job comparing tax-free retirement options.
When working with clients, I have noticed the best savers for retirement are often the worst spenders in retirement. This can cause a huge tax problem when the majority of their retirement savings are in a traditional 401(k)/IRA retirement account, because they delay paying the tax until they die and then the tax has to be paid on the entire balance that year, pushing them into the highest tax bracket.
Don’t get me wrong, I am a huge fan of people putting money into any retirement account that has an employer match, as long as they realize they have not paid the tax yet and plan accordingly. Conversely, in a tax-free account, it generally gets better for your legacy the longer you live because of the way it passes on the tax advantages. I believe in using multiple strategies through a balanced holistic approach, which usually incorporates all three categories of accounts.
An amazing attribute regarding Roth accounts and maximum funded life insurance is that they generally pass on to the beneficiaries tax-free. An important question to ask is which account is more efficient in the long run. An aspect some people usually don’t consider with a managed Roth account is that it gets more expensive as time goes on because you typically are paying a management fee that corresponds with the growing account value. In contrast, with a maximum funded life insurance policy, you pay premium expense loads and additional expense charges that generally go away after 10 years, potentially making it a more efficient post-tax vehicle in the long run.
Additionally, the maximum life insurance policy completes itself through a death benefit in the short run if, God forbid, the individual faces a premature death. So, if your time frame is less than 10-15 years before you will most likely need to access the monies, we usually recommend a Roth IRA and, if your time frame is longer than 15 years, we take a look at utilizing a maximum funded life insurance policy. Both Roth and maximum funded life insurance can get you on the path to tax diversification, but, most importantly, you are not at the mercy of higher tax rates because all of your retirement savings are in taxable accounts.
In the last 5 years I have not heard one good argument for taxes being lower or staying the same in the future, therefore it will make more sense for your retirement to pay the tax now.
If you were a farmer, would you rather pay tax on the seed or the harvest? Ninety-nine percent of all people I have asked this question say on the seed, and rightfully so. Which one would the government want you to pay tax on, the seed or the harvest? Almost everyone I have met says the harvest, which could be the motivation for allowing you to delay the tax liability. Second, have you ever thought about how Wall Street, financial institutions, and financial advisors, get paid? Typically on the amount of your money under management, meaning, if someone only had $5,500 this year to put away for retirement, in a traditional taxable IRA they can put the whole amount into the account and delay the tax liability.
If the same person were to put the money into a Roth IRA or maximum funded life insurance policy, they would have to pay tax before they put it into the account, meaning in a 28% tax bracket, $3,960 is what is left to save for retirement. Most people don’t put two and two together and realize that Wall Street, financial institutions, and the financial planner will make more money if you put the money into traditional IRAs and 401(k)s because it will grow to a larger number.
Having the foresight and fortitude to balance out your retirement accounts and create tax diversification can give you more control in retirement. One of the best examples would be someone who withdraws money from their traditional 401(k) / IRA accounts up to the point where zero of their Social Security is taxed, ultimately maximizing their tax bracket through the use of withdrawals from their tax-free accounts. The higher you think taxes will be in the future, the more you should allocate to a tax-free account now.