Save for Retirement part 3 – Why a tax-diversified strategy makes good sense

Save for Retirement part 3 – Why a tax-diversified strategy makes good sense

This post is the third in a series about saving for retirement through a tax-diversified savings plan.  Bored yet?  Yes, I am again suggesting you read about taxes and retirement savings.  Once again, you may be questioning how I ever met a girl, let alone got married.  Full disclosure:  it’s a mystery to me too (how someone agreed to marry me that is, not the tax planning/retirement savings). 

In this post I am going to mix up a strange concoction of ingredients – the sweet smell of retirement (or freedom-ment, call it what you will), along with the slightly putrid flavor of taxes.  But, sometimes disparate ingredients make for a tasty dish – for instance, a good Thai curry requires both the sweet zip of palm sugar and the nasty tang of fish sauce. 

To describe the idea, I could dive into details about taxes and tax-favored retirement accounts.  Yawn.  Instead, I am going to write about it in the language of a story about two fictitious people, Gabriel and Julia, who want to spend more time surfing and wiggling their toes in sand.  Theirs is a story I want to read, and one I get excited about writing about. 

This is the third post in a series about saving for retirement.  For parts 1 and 2, you can read:

Save for Retirement 1:  What is retirement?  In this post, I discussed how the concept of retirement is more about transition with purpose, and less about an ending of work.   

Save for Retirement 2:  What type of retirement account should you use?  In this post, I described the differences between “pay your taxes later” accounts (like a deferred compensation plan, 401k or traditional IRA) and “pay your taxes now accounts” (like a Roth IRA).  

30-second summary of this blog post  

You should save for retirement using different tax-advantaged accounts:  with tax-exempt accounts like a Roth IRA accounts AND with tax-deferred accounts like a 401(k) or deferred compensation plans.  “Why?” you ask.  Read on…

Gabriel and Julia’s story

Gabriel worked his entire life as a firefighter.  He is married to Julia, and they have two grown children.  Gabriel is 59, and wants to retire next year after 30 years of service.  His wife, Julia, owns a small interior design business;  she would like to keep working for a few more years.  Over their working lives, they regularly saved for retirement.  Early on, when their kids were young and Julia was starting her business, they couldn’t manage much savings.  But, in the last few years they have been socking it away.  They now have a decent nest egg built up, as well as Gabriel’s pension to help pay for their retirement.  

Gabriel has always loved surfing, and after retiring, he wants to do more.  He has his eyes on buying a condo on the Hawaiian island of Kauai.  Julia loves the idea as well.  She also enjoys water sports, but her dreams are more about chasing their grandchildren around the sandy beach.  They both want to invest into a place, and remodel/decorate it into a home of their own style.  They will need $300,000 from retirement funds for a down-payment and remodeling costs. 

Cue intermission while the financial planner makes sure the numbers work, and that they wouldn’t be sabotaging their other less glossy dreams (like eating when they are 75, or going to the doctor).  Beep, beouw, whop, beep, bwow.

Hooray!  The numbers work and the planner gives a thumbs up to Gabriel and Julia.  They open up Zillow and start searching…

Two different scenarios

To use this story for my greater purpose, I am going to illustrate two separate retirement savings strategies that Gabriel and Julia could have used.  In scenario #1, I assume Gabriel and Julia saved only in tax-deferred accounts.  In scenario #2, I will assume that they saved in both tax-deferred AND tax-exempt accounts, like Roth IRAs.  

A quick refresher on different types of tax-advantaged accounts:

  • Tax-deferred accounts, AKA “Pay your taxes later” accounts.  In these accounts, the saver contributes money, but does not pay federal income tax on the contribution.  Eventually, when the money is withdrawn for a qualified purpose, it will count as “ordinary income” and be taxed as such.  Most employer sponsored retirement plans (that are not pensions) fit this category.  Examples are 401(k) plans, Deferred Compensation (457) plans, SIMPLE and SEP IRA plans, TRS3 Defined Contribution, and Traditional IRAs.
  • Tax-exempt accounts, AKA “Pay your taxes now” accounts.  In these accounts, the saver contributes money after taxes are paid.  Eventually, when the money is withdrawn for a qualified purpose, there will be no tax owed.  Usually, these contributions are called “Roth” contributions.  The most common type of account is a Roth IRA.  

Back to the scenario comparisons.  For mathy notes about how I made the comparisons fair, see note [1] at the bottom of the page.  

Scenario #1:  Gabriel and Julia have a decent retirement nest egg to use:  $1,124,000 between Gabriel’s Deferred Compensation plan and Julia’s individual 401(k) plan.  If Gabriel withdraws the $300,000 from his Deferred Comp plan, he would actually have to withdraw $423,000 to cover an anticipated tax bill of $123,000.  Remember, a tax-deferred account is a “pay your tax later” retirement savings account.  Thus, taxes will be due when he withdraws the money.  After the withdrawal, their retirement portfolio would be worth about $700,000.

Scenario #2:   Over the course of their careers, Gabriel and Julia put about one-third of their retirement saving into tax exempt accounts – each of them has a Roth IRA.  Since they paid tax as they went, they ended up with a smaller overall nest egg, about $1,040,000. They have $300,000 in their Roth IRA, and $740,000 in their tax-deferred accounts.    They carefully examine the tax rules and realize that they can withdraw the entire $300,000 from their Roth IRA accounts without any tax consequence.  They will owe $0 tax on the withdrawal.  After the withdrawal, their overall retirement portfolio is about $740,000.  

The two scenarios are illustrated below.

How a tax-diversified retirement savings strategy can work

Now for some details on the strategy…

Retirement withdrawals

In retirement, it is likely that your income won’t be enough to pay for a great life.  Maybe you’ll want to travel more, or buy and maintain a vacation property.  Maybe you just like great wine.  Maybe you want to open a niche-focused surf school for people with gray hair.  To pay for it, you will need to access all those retirement savings you’ve been stockpiling.  Most people do.  There are essentially three options.  You can withdraw from a:

  1. Tax-deferred account (like a 401(k) or deferred comp plan).  The withdrawal will be reported on your tax return as income.  So, it will push up your taxable income, and thus your marginal tax rate.
  2. Tax-exempt account (like a Roth IRA).  This withdrawal has no tax consequences.  There are probably a bunch of picky rules and exceptions, right?  Nope.  (As long as it is a qualified retirement withdrawal).
  3. No tax advantage account (like a regular brokerage account or real estate sale).  Depending on how long you owned the asset, there will be capital gains taxes owed. 

The key idea in this blog post is how a withdrawal from your retirement account will affect your future taxes.  If you have options from which account to withdraw funds, you can manage your situation to save on your overall tax bill.

In retirement you still have to pay taxes

When you are retired, you will still have to file tax returns.  You will hopefully have numerous sources of income in retirement.  You may have social security, a pension, rental property income, maybe a part-time business teaching those-with-gray-hair to surf .  You will have deductions and adjustments.  Then, you will owe tax on your taxable income.  The more taxable income you claim, the more you will pay in taxes for two reasons:

  1. Math.  Example:  $100,000 times 15% is more than $40,000 times 15% (Result:   $15,000 is more than $6,000)
  2. Tax brackets.  We, as US tax payers, pay taxes in “tiers,” or brackets.  Each bracket has a different tax rate.  I like to think of them as buckets.  Every tax payer, no matter their income, pays a low rate on the first bucket of taxable income (for married filers, it’s 10% on the first $19,050).  The next chunk of money pays a higher rate, so on and so forth, until all taxable money is accounted for.  When you make more, you fill buckets with higher tax rates.  You can read more about the tax brackets in the following blog post:  How about them taxapples? Tax brackets and harvesting benefits through savings.

In scenario #1 for Gabriel and Julia, they incurred an additional tax of $123,000.  Why?  Two reasons:

  1. Math. The withdrawal from the Gabriel’s Deferred Compensation plan become taxable income, and
  2. Tax brackets.  Their increased taxable income pushed them into a much higher tax bracket.  Under 2018 tax law, their marginal tax rate jumped to 35%.  

Other scenarios

There are there other scenarios where different life choices, and different tax situations, might lead to different outcomes.  That is the reason why good financial planning is individualized.  Here are a few other possible scenarios related to this topic:

  1. Tax rates rise in the future.  This could occur by you making more money in the future than you do now, or by the actual tax brackets going higher.  I’ll let you imagine why/whether future tax rates could be higher than today (ahem, US national debt).  Under such a scenario, having contributed money at a lower tax rate (in the past) would be beneficial.
  2. Tax rates go down in the future.  If this were to happen, then you would be better off saving in a tax-deferred account.  It may happen, and political forces make that even more likely.  But, are lower and lower taxes sustainable?  That question is much tougher to answer, so I’ll let you ponder.  I prefer to make future assumptions in a more conservative way.
  3. You save only in tax-exempt retirement accounts (like a Roth IRA).  Although it may sound great to never owe taxes in the future, this is not a great strategy.  In this case you would owe almost no tax with the withdrawals.  But, if you need to take smallish, ongoing withdrawals in retirement to pay for say, groceries or health care, you might end up be claiming only a small amount of taxable income, and so would pay a very low tax rate.  Paying higher taxes earlier, and avoiding lower taxes later, is not smart.  Thus, having all your eggs in only a tax-exempt retirement savings basket is not a good idea.  The good idea is tax diversification.

Conclusion

By using a tax-diversified savings strategy (scenario #2), Gabriel and Julia saved around $92,000 in taxes.  Their retirement portfolio balance ended higher after buying the condo.  If they hadn’t saved in a tax-diversified way, they would have incurred a $123,000 tax bill as a result of raising money for the condo.  Such an event might cause anguish for Gabriel and Julia.  How much anguish?  I can easily imagine these sort of conversations:  

Sweetie, if we do this, we are getting hit with a $123,000 tax bill.  That money could go towards our grand childrens’ college fund.  Isn’t this condo idea a bit extravagent?”

Honey, I love the thought of owning a condo in Hawaii that fits our lifestyle.  But, spending $123,000 in taxes on our hard-earned money is irresponsible.  Let’s put this idea off for a while.”

I can easily imagine that a $123,000 tax bill, could be a dream killer. 

In this example, the numbers support a tax-diversified strategy.  But, life and dreams are not about numbers.  Life is about setting up a home, floating in the salt water, carving down the face of a wave, or running with grandchildren on the beach.  A wonderful part of life, and the really fun part of financial planning, is about making dreams a reality.  A tax-diversified retirement savings strategy can provide options when the time comes to pay for your dreams.  

If you would like to learn more about a tax-diversified strategy, or to find out how it might fit into your retirement savings, or if you just want to do some dreaming, you can book a consultation with John, and click on “Schedule a Free Consultation.”  Thanks for reading, feel free to share this post if you found it useful.


Notes and references

[1] – To make the comparison fair, I assumed the total amount that Gabriel and Julia saved over their working careers was the same – about $360,000 over 30 years.  During their first 10 years, I assumed they saved a total of $6,000/year, during the last 10 years I assumed $18,000/year.  In scenario #2, I assumed that they saved 35% in tax-exempt accounts ($3.50 out of every $10 saved).  During their working years, I assumed their marginal tax rate slowly increased from 15% to 28%.  Over 30 years, the taxes they paid added up to $31,000.  I also assumed an 8% investment return.  Disclosure:  I am not advocating for anyone to actually follow these values for their own personal finances.  They were used for illustrative purposes only.

John Chesbrough
john@trailfp.com

I am a financial planner and investment manager. I also am the owner of a fee-only, independent financial advisory firm called Trail Financial Planning. I enjoy working with people who care for others and their community – parents, firefighters, therapists, doctors, nurses, and teachers. I may be spotted at through my blog or on the many winding trails of Whatcom County. To learn more, or contact me directly, please visit my firm's website: www.trailfp.com.