Taxes are probably the most important part of your retirement plan. Your tax strategy is possibly even more important than your asset allocation and like the asset allocation, there is no one size fits all approach. There is however a relatively similar path that most people should follow in order to maximize their returns and minimize their tax impact. The below lays out how you should be investing your money in order to do just that. There are exceptions to the below rules but we’ll talk about those later.
Note that I do not mention a savings account in the below strategy. However, I am a firm believer that you should keep 4-6 months living expenses in a safe savings account that you can access at any time. Job loss and unforeseen expenses happen and you’ll be glad to have that buffer when they do and you won’t have to liquidate any of your stock position creating taxable gains or potentially selling during a down turn.
What makes tax-advantaged accounts like the HSA, ROTH, Traditional IRA and the 401k so great is that they allow you to have a ton of flexibility around your current and future tax planning.
This all comes down to how our tax system is currently structured. For simplicity’s sake, I’m using values of a single filer with the below adjusted gross income before 401k/Trad IRA deductions.
Under our current system, the first dollar you earn is taxed at a lower rate than the last dollar you earn. If I make $50000/yr, that puts me in the 25% marginal tax rate bracket but that doesn’t mean I pay 25% of that in taxes. For 2016, I would pay 10% on the first $9275, 15% on the next $28375 and 25% on the next $53500 and that continues until we reach the final tax bracket of 39.6% for any income of $415051. Now why does that matter? It matters because we can take advantage of this system to maximize our savings potential and minimize taxes paid.
What makes these tax-advantaged accounts like the 401k so good is that the dollars you invest in your 401k are the last dollars you earned which means they are taxed at your highest marginal tax rate. This can be as high as 39.6% depending on how much you make and this number plays a big role in answering the question of whether or not the Roth or Traditional options are better for you.
The Roth IRA or Roth 401k if offered doesn’t offer that same tax-savings but does offer the benefit of being tax free upon withdrawal. This makes it a better option if you think that you’ll end up buying a higher tax rate in retirement but what are the odds of that happening?
Let me use myself as an example. I make less than the $91000 needed to put me in the 28% marginal tax rate so if I use a 401k or traditional IRA, I’ll save 25% on each dollar put into the 401k. If those contributions were to bring me below the 25% marginal tax rate line, I’ll save 15% on the additional dollars in that range. In my case they do not so for every dollar I put into my 401k or traditional IRA, I save 25% by deferring taxes until retirement.
In order for a Roth IRA to make sense for me, I’d have to have an effective tax rate of 25% or higher in retirement. Now how likely is that to happen? Remember that we’re in a marginal tax rate system which means that the first dollar is taxed at a lower rate than the next dollar assuming that dollar brings it into a new tax bracket. 401k/Trad IRA distributions are handled like regular income so that means that if I were to retire today, I’d pay 10% on the first $9275, 15% on the next $28375, etc. until we reach my actual income. If I want to get an income of 80k, I’d be paying an effective tax rate of
19.7% which is quite nice considering I saved 25% on the front end when I put the money in and will only pay 19.7% on the back end when I take it out.
To reach an effective tax rate of 25%, assuming no other earnings, I’d have to take out over $190000. That’s quite a jump in earnings if I want to have the same 25% tax savings on the back end. Now this is obviously a best case scenario type of thing as my 401k withdrawals could and will be subsidizing income from other sources like social security and pensions and as such could be taxed at a higher marginal tax rate but it does serve to illustrate that sometimes a Roth IRA just isn’t that great.
This is not to say that you should always choose a traditional IRA over a Roth because that’s not the case either. The Roth IRA is a bit more flexible allowing for things like removing your contributions(not earnings) without penalties which can be nice. A Roth IRA is also a better tool for estate planning(if you plan to pass the money on to your kids) as it is not subject to required minimum distributions like an IRA can add a good deal of value in continued tax-free growth. Also, since the 401k saves you money on the last dollar earned, it may also make sense to choose a Roth if your last dollar is earned in the 15% or lower tax bracket since it’s quite possible your taxes in retirement would be higher.
Another factor will be your income. Note that if you are covered by a retirement plan at work then the deduction you get for a traditional IRA begins to phase out at modified AGI of 61k and is completely gone at modified AGI of 71k. If you make above that level then the Roth is naturally a better option.
The other and more important factor that may drive you to choose a Roth over a traditional IRA is that it provides a level of diversification when it comes to taxes. The numbers I used above to illustrate my point are based on 2016 tax tables. Let’s say that instead of retiring in 2016, I choose to retire in 2026 and look at the tax tables then. What if the bottom marginal tax rate is now 25% and the top is 75%? I’d have saved 25% on the front end and have to pay an illustrative 35% on the back end because taxes have gone up as they so often do these days. Another example might be an increase in income/living expenses. What if I earn $80000 this year making my marginal tax rate 25% but retire in a much more expensive area and require $400000/yr to live making my effective tax rate greater than 25%. In both of these situations or a combination of both, a Roth IRA would have likely been a better idea which is why I actually do have a Roth IRA instead of a Traditional IRA even though I don’t believe the current tax climate really makes it all that enticing. I do it because I think there are future uncertainties around the tax code that may mean I’ll be in a higher effective tax bracket when I retire than the marginal tax rate I am in now.
That’s why my retirement plan has a combination of the standard 401k and HSA which have front end tax advantaged savings and the Roth IRA which has a back end benefit.
In my case, I max the 401k then do the Roth IRA. I do have access to a Roth 401k at work but I like the guaranteed 25% tax savings over the potential for higher tax savings in the future. If taxes do go up and brackets change in an unfavorable way, I do have the Roth IRA to take some of that sting off the back end.
What’s nice about the 401k and Roth IRA setup is that even if taxes do go up, you can still have some control over your effective tax rate since you can take 401k distributions up to a certain marginal tax bracket(let’s say 25%) then take the Roth IRA distributions tax free after that.
Now the problem some will have in this scenario is that a lot of these accounts are retirement accounts to be used after a certain age which is generally long past a person’s ideal early retirement age. There are ways around that which I plan to utilize like Roth IRA conversion ladders and 72(t) early distributions but it also helps to have an account you can access at any time without penalty to help buffer the years between early retirement and what the IRS considers retirement. That’s where taxable accounts come into play. Tax-advantaged accounts which allow you to reduce your tax burden and therefore invest more are certainly the first line of investing but it helps to combine them with taxable accounts when talking about early retirement. The rules around early withdrawals, whether through early distributions or conversions are complex so it can help to have some taxable accounts with no rules around access before you get your conversions/early distributions ironed out.
This is your standard brokerage account. You invest after-tax money and pay taxes on any gains and dividends in these accounts. As such they don’t grow as fast as a tax-advantaged account and you’re also putting in after tax money here so the amount of money you can invest is less than what you put into your 401k.
In my case, I have two broker accounts, one through my employer for the employee stock purchase plan and one through vanguard for access to their ETFs.
The most important thing when it comes to taxable accounts is tax management and that is one of the most important things when it comes to overall return and one of the things that will likely sink most individual investors when it comes to their returns versus the marketplace.
Since this post has gotten a bit long, I’ll talk about exactly what I do when it comes to taxable accounts in another post. The main idea is proper security placement within your tax-advantaged accounts and your taxable accounts and a long term plan in your taxable accounts to qualify for the long term capital gain tax rates.