We have often told clients over the years that long-term tax planning is not what happens when you receive your December issue of a personal financial planning magazine in mid-November. Effective tax planning, particularly for retirement, is a multi-year approach.
Just this week, I read an article entitled "How to Avoid the Retirement 'Tax Cliff'" in Financial Planning magazine. The focus of the article was that if you have been a diligent contributor to your retirement plan over the years, you may be in for a surprise once those funds begin to be withdrawn and are subject to ordinary income tax. Even if you attempt to stave off the tax collector, there is always the specter of Required Minimum Distributions looming at age 70½. Accumulating a substantial amount in a tax-deferred account is not uncommon, as we are constantly bombarded by the financial news media and financial planners to do so. While I am certainly not against accumulating funds in a tax-deferred account, it should be done within the framework of an overall strategy. Let's take a look at an alternative method to accumulating your assets.
Let's say that your employer offers a traditional 401(k), with a match formula of 50% of your contribution, up to a maximum of a 3% match. As you are fully capable of deferring more than the 6% that is eligible for the match, you defer 10%. You do this because it is fairly simple, it requires little discipline to be a plan participant, and because everyone tells you to defer the maximum you can on a pre-tax basis in order to reduce your current tax load. You do this at one employer, or a procession of multiple employers, arriving at the time of your retirement with a substantial amount saved in tax-deferred accounts. Unfortunately, it was very difficult throughout your working career to save funds outside of your employer-sponsored plans due to raising children, paying college tuition for same, vacations and other necessities and luxuries of life; the only after-tax dollars you have at retirement are those residing in your wallet. As you draw upon your nest egg in retirement, it does not take long to realize that every dollar you are taking out to support your lifestyle is subject to ordinary income tax, much like during those years you were earning a salary.
Now, we contrast this scenario with one in which you did not defer all of your savings in tax-deferred accounts. Maybe one, or all, of your employers offered a Roth 401(k), so you deferred your 6% into the Roth option, with the knowledge that the match and any profit sharing contribution that might be made are going into the tax-deferred portion of the plan. Just for this illustration, let us assume that there is a 3% match and a 3% profit-sharing contribution, which means that over time, there is the potential for you to end up with 50% in tax-deferred and 50% in after-tax accounts. In this example you have also spent funds on raising and educating children and spending your take-home pay on enjoying life. The big difference in this case is the after-tax capital you have accumulated. Why is that so important?
One of my favorite words in finance is liquidity. While it can have many definitions, I prefer to define it as follows: "the ability to get to your money, at the time you need it, with the minimum amount of penalty." The word penalty can also have a number of definitions, including the stock that gets halved on the day you want to sell it, an actual penalty imposed by the IRS, or maybe just a higher tax rate on the funds you are withdrawing. In the case of having all of your funds in a tax-deferred account, you may face a penalty of sorts upon withdrawal in the form of higher taxes, which then affects your liquidity. The goal with income taxes, at least in my opinion, is to have the lowest rate for the longest period of time. This is difficult if your income is highly variable during your working years, but the point of this discussion is that we don't want to accumulate after-tax capital with the goal of drawing this down first in retirement in order to have zero taxes for just a few years, leaving us then with only tax-deferred accounts, and therefore eliminating all the advantages we built up over the years. If you have accumulated both pre-tax and after-tax capital, you must employ an effective strategy for withdrawals in order to properly manage your tax rate.
If you are within 5 years or less of retirement and have primarily accumulated funds in tax-deferred accounts, the die is cast with regard to your withdrawal strategy in retirement. However, if you are in your 30's or 40's, now would be a great time to begin saving on an after-tax basis, regardless of the vehicle (Roth, brokerage account, etc.) involved. While you may feel you are paying slightly more in taxes today, and indeed that may be the case, the advantages of such a strategy will pay off handsomely when you are retired. You will enjoy liquidity
and the ability to have more control over your effective tax rate.