For many people, the main concern in the ten years leading up to retirement is making sure they save enough money. This is, indeed, an important concern. However, saving in the right way should also be ranked at the top of the priority list. American workers have been told for years that they would be in a lower tax bracket during retirement. Therefore, deferring income through employer sponsored plans like a 401(k) or through traditional IRAs and tax-deferred annuities was a sound strategy. That was before the national debt reached $23 trillion ($187,000 per taxpayer) in 2019. In the future, tax rates are likely to go up, not down. Anyone who wants to retire into a lower tax bracket will need to plan for it.
The national debt is a mere drop in the proverbial bucket compared to the $70 trillion1 the government will owe in benefits to Social Security and Medicare recipients far into the future, as well as in pensions to military and civilian government workers. The government is going to need money—and a lot of it. Politicians have already made proposals that include capping the amount that can be saved in retirement accounts and taxing amounts in retirement accounts if they exceed a certain threshold. Means testing is already taking place with Medicare premiums. Total income during retirement affects the amount of a retiree’s monthly Medicare premium.
Anyone who has done a good job saving for retirement on their own should consider the possibility that Social Security benefits could also be means tested in the future. A likely method of means testing could be to adopt the one currently being used for Medicare Premiums. If your income is higher than a certain threshold, your benefits will be reduced.
This may not seem fair, but we have little control over it. What each of us can control is taking the right steps toward protecting retirement assets from higher taxation. Even a novice investor has heard of the importance of diversification as a tool to lower risk. The main concept is to avoid concentrating assets in one position that could cause serious harm if the investment doesn’t work out.
Diversification based on taxability is just as important for retirement. Simply put, tax diversification involves allocating investment assets across accounts and investment vehicles that are taxed differently — taxable, tax-deferred, and tax-free. We call these three vehicles the New Three-Legged Stool™ of tax-efficient retirement planning. The New Three-Legged Stool™ strategy was first put forth in a book by the same title published in 2009. The book was updated in 2017 and retitled by the new publisher as Don’t Retire Broke: An Indisputable Guide to Tax-Efficient Retirement Planning and Financial Freedom.
Successfully building a tax-efficient New Three-Legged Stool™ takes preparation. Many employees believe saving in an employer-sponsored plan is the easiest way to discipline themselves to put money aside for retirement. Unfortunately, ending up in retirement with 100% of savings in a tax-deferred account will provide no flexibility to reduce income taxes or minimize the impact of means testing. A retiree will need to have some of their savings in a tax-free Roth and some in an after-tax account. The retiree can withdraw some income from all three savings legs in a way that could minimize taxes and means testing.
A sound tax diversification plan includes the following techniques:
Allocate assets by tax treatment
You can reduce the tax on your distributions by following these two asset location guidelines:
- Generally speaking, put all of your equity investments (or as much as possible) in your taxable account and your Roth account. Why? In your taxable account, equities are taxed at favorable long-term capital gains and qualified dividend rates. Currently, these rates are much lower than ordinary income rates. In your Roth account, equities, which have the greatest opportunity for growth, are tax free!
- Generally speaking, put all of the fixed income investments (or as much as possible) in tax-deferred accounts like your traditional IRA or 401(k). Why? In your tax-deferred accounts, every dollar you withdraw is taxed at ordinary income rates. Having equity investments in your deferred accounts can be viewed as a waste of the favorable tax treatment they receive in a taxable account or a Roth account.
Use tax-free bonds when holding fixed income in taxable accounts
It is not always practical to hold all of your fixed income in retirement accounts and all equities in non-retirement accounts. Consider using municipal bonds when fixed income must be kept in non-retirement accounts. Municipal bonds are free from federal, and, in some cases, state and local income taxes. These bonds are particularly advantageous for investors in the highest tax brackets. Tax-free bonds may even be attractive to those in lower tax brackets when yields are equal to comparable taxable fixed income securities. Use equity investments with higher dividend payments such as real estate investment trusts when equities must be held in retirement accounts.
Find ways to fund a Roth regularly.
Having the ability to save after-tax in a Roth provides a valuable way to save tax efficiently. The priority should be funding a Roth IRA or Roth 401(k) account based on careful tax planning each year. Consider only putting enough money in a traditional tax-deferred account to stay in the 12% tax bracket. This will require estimating taxable income to determine optimum tax deferral and saving additional funds in a Roth.Secondly, consider converting part of an IRA to a Roth in a year when taxable income will be in the 12% tax bracket. Conversions may appeal to IRA owners who do not expect their tax rate to be lower in retirement. The conversion feature should appeal to those who have a lot of time ahead of them, while their accounts can grow tax-free. Be sure to seek qualified tax advice before electing to convert. While conversions are not subject to the 10% early distribution tax, the amount converted is taxable. Recent tax law changes have eliminated the ability to undo conversions through re-characterization.
The New Three-Legged Stool™ approach
The New Three-Legged Stool™ approach to retirement is based on balancing savings between tax-deferred, after-tax and tax-free accounts. John Sample, a single individual, has done an efficient job of saving for retirement and has balanced savings. $667,000 is in tax-deferred IRA/401(k) accounts. $667,000 is in an after-tax account and $666,000 is in his Roth IRA tax-free account. His total retirement savings of $2 million is projected to distribute 4% ($80,000) per year based on the prudent withdrawal rule. If John had saved everything in his 401(k) and IRA accounts, the $80,000 of income would all be taxable. In this example this amount of income, together with Social Security benefits of $25,000, would make his Medicare premiums subject to means testing.
Fortunately, Mr. Sample saved tax efficiently. The tax liability from the after-tax account is not based on the amount of withdrawal because some would be considered a return of principal. Assuming Mr. Sample follows the asset location strategy we recommend, there will be some tax implications from dividend distributions and rebalancing. There is no tax liability from any qualified Roth withdrawals. Mr. Sample reports $47,000 of taxable income, of which most came from the IRA/401(k) withdrawal. Therefore, he will pay less in income taxes and his Medicare premium will not be subject to means testing.
The New Three-Legged Stool™ approach provides a retiree with the flexibility to pull the income needed from the most tax efficient location each year. This is the reason why you should focus on saving efficiently and not just on the amount of savings you’ve accrued in the ten-year period before retirement.
- Saving tax efficiently is just as important as saving enough money for retirement.
- Tax diversification is allocating assets across accounts and investment vehicles that are taxed differently — taxable, tax-deferred, and tax-free.
- A retiree can control their income taxes and means testing when they have followed the New Three-Legged Stool™ approach to retirement planning.
1 Source: www.justfacts.com/nationaldebt.asp