The market will ebb and flow. We cannot foretell how it will perform from day-to-day, week-to-week, month-to-month, and sometimes year-to-year. However, we do know the general direction, over several years, will be “Up.” Therefore, it makes little sense to stay awake at night worrying about the volatility we’ve seen over the last year.
What has me tossing and turning, at times, is the nagging notion that I could be doing better for my clients … am I leaving ‘no stone unturned?’ We’ve compiled the relevant numbers and set up an efficient, well-diversified portfolio. But, what more could I be doing for you?
As part of my blog series, I am going to examine points at which many advisors fall short in service to their clients (and what can be done about it). This quarter, I wish to highlight: Tax Diversification
The vast majority of my clients are on track to have enough saved for retirement but, most of them will only possess taxable retirement funds at the time they separate service from their employer. This severely limits their ability to control their tax liability, when large withdrawals are needed. An added complication, the majority of FPF clients have at least one pension in the household; if extra is needed, there is a good chance that withdrawals from 457 and 401 accounts will push them into the next tax bracket.
One objective of saving into a qualified plan is to keep a noticeable separation between the tax bracket you are/were in when contributing to the retirement plan versus your bracket when making withdrawals. If you were avoiding the 25% tax bracket by contributing to a workplace plan, having a 12% liability on the withdrawal will lock in a real 13% rate of return on your money. Now, if someone had to take out more than what would allow them to remain in the 12% bracket, the next bracket is 22% and, while a built in 3% rate of return is still nice, it just takes a little planning and commitment to run your after-work tax life a bit more efficiently.
Though it is easiest to do it, every retirement dollar should not be saved into workplace plans. Some should be directed toward a Roth IRA or a non-qualified investment account. The idea is simple but, the follow through is not. Logistically, starting a savings plan with small amounts is a cumbersome process with little initial reward and a high instance of abandonment.
Let’s start with the Roth IRA. As long as your income qualifies, you can add up to $500 per month to a Roth IRA ($583, if reaching age 50 or beyond in the calendar year). Your advisor can help you set up one of these accounts but, you will have to associate an ACH withdrawal from checking/savings. For some, this is a non-starter because they spend whatever comes home and these transfers could stall shortly after they begin.
If you make too much to qualify for Roth IRA contributions, there is a ‘back door’ into the Roth. Persons wishing to take advantage of this provision can contribute to a Traditional IRA and not take the deduction on that year’s taxes (also known as a Non-Deductible IRA). As long as another, taxable IRA doesn’t exist under the same SSN, the owner of the Non-Deductible IRA can convert the balance to Roth status without creating much (if any) of a tax liability. A major difference between a Contributory Roth IRA and a Converted Roth: Account holders of Contributory Roth can access their principle at any time while those who convert must wait five years after the conversion to touch the principle.
Some retirement plans allow for a Roth contribution to be made. There are no income limits for contributions but also no access to any of those funds until you have separated service from your employer. Additionally, workplace retirement plans limit their investors to a small group of pre-selected mutual funds. Chances are unlikely that a diverse range of quality, aggressive investments is available through a retirement plan lineup.
To get a non-qualified, taxable account up-and-running, mutual funds are generally used to build a balance. Selling shares rarely incurs a penalty (unless there’s a 90 or 180-day restriction imposed by the fund company). Selling a mutual fund could create capital gains taxes (at marginal tax rates, if held less than a year, and at no more than 15%, if held over a year). Along the way, mutual funds will also kick off dividends and distribute gains which will affect your annual tax liability. You’ll have additional tax documents and a little more work to do, when filing your tax returns.
Note: For every dollar you reduce your 401 / 457 / 403 plan contribution in favor of one of the two options laid out above, you return approximately 80 cents to your paycheck. It will appear as if less is being saved, especially if you choose a taxable account.
From an advisor standpoint, there are a few issues with starting savings programs as described above:
- The money is too accessible. People raid savings that’s only arm’s length away.
- People tend to leave employer retirement plans alone but, are all-too-willing to adjust ACH drafts from their checking accounts on a regular basis.
- Of a universe of 25,000 investments, very few (about 500) allow monthly automated investments under $250 per month. Of those, less than half can be considered ‘quality’ funds.
Taxes are lower, at this time, than any point during the last three decades … unsustainably so. With our national debt surpassing $22 trillion, there is little doubt in my mind that we will all be paying higher taxes, sometime in the next decade. Saving into a retirement account to avoid a 22% tax liability might not have the same cache, if your tax bracket in retirement will be higher!
Having accounts with differing taxability will allow you to manage your liability during years of unexpected expenses. We were all promised flying cars by now. When the hovercraft does become commercially available, would you rather take $70k from a pre-tax retirement account to net out the $50k for the vehicle, perhaps pushing you into the next tax bracket, or would you prefer to liquidate $50k from the Roth IRA and maintain the lower tax bracket? If you favored the latter, you should sit down with your advisor to figure out how much should be put toward an account type with a different taxation profile. This must come alongside the understanding that a ‘watched pot never boils’ … it will seem like an insignificant amount of money that isn’t growing … but, like any other investment, time will be your greatest ally and you’ll be glad you have choice(s) in the future!