It has been said that the only certainties in life are death and taxes. While that may be true, we can minimize the latter with some good planning.
Investment tax planning can be as much an art as it is a science. That’s because the rules are always changing. My general philosophy is to “not let the tax tail wag the dog.”
I’ve seen too many people lose the better part of their investment assets trying to engage in tax dodges. Their emotional desire to “get one over on the government” can overcome their sensibility. Investment salespeople often play on this emotional desire, take advantage of unsuspecting investors, and then disappear with no liability just as long as all the disclosure paperwork is signed.
It is critical to have a basic understanding of how taxes can affect investments. Once you do, then you have a working knowledge of how to work on reducing the overall tax drag on your financial picture. With that in mind, let’s walk through some tax concepts that you can put to work.
Three basic tax advantages
When it comes to investing, there are three basic tax advantages that we need to be aware of as we are making investment decisions.
1. Tax deductibility
When you have earned income, you typically pay taxes on that income. I will cover this more in a little bit, but the basic notion is that you are in a partnership with the Federal Government in that they get a portion of the income you earn from your work. In general, you can earn some money and not have to pay taxes on it.
If you have ever looked at a tax return, you are familiar with the concept of the “standard or itemized deductions.” They refer to the amount of money you can subtract from your income as part of the formula to determine your “taxable income.” Anything I can do to reduce taxable income helps me reduce the amount of my income that I “share” with the government.
In addition to being able to take standard or itemized deductions, we are also allowed in some cases to deduct contributions to investment accounts. Examples of investment programs that may allow this would be: Traditional IRAs, 401(k)s, 403(b)s, Simplified Employee Pensions (SEP), SIMPLE plans, etc.
Gross income – deductions = taxable income
Deductions allow you to reduce the amount of income you must pay taxes on, keeping more money in your pocket.
2. Tax deferral
Tax deferral is where you can put off paying taxes on investment gains until some point in the future—typically in retirement. You put money into the account and then you don’t pay any taxes on it until you withdraw the money.
Meanwhile, with the funds invested, you can expect the account to grow over time. Without the benefit of deferral, you would owe taxes each year on the growth, significantly limiting the total value of the account come retirement.
Imagine being able to defer taxes on the income you earn from work. You could keep all the money you earn, do whatever you want with it, and then you wouldn’t have to pay any taxes on it until a later date, potentially when you’re in a lower tax bracket.
Not only that, but this growth is subject to compounding. More on that in a minute.
As the name implies, this is where you are allowed to pull both principal (what you deposited) and gains without any further taxation. Some examples of this might be: Roth IRAs, Roth 401(k)s, and municipal bonds.
Like Roth retirement plans, traditional retirement plans like the IRA, 401(k), SEP, etc. also benefit from tax deferred earnings growth. In other words, they give you advantage one (tax deductibility) and advantage two (tax deferral).
While Roth IRAs and Roth 401(k)s don’t benefit from a tax deduction, they do give us tax deferral on earnings and tax-free income upon withdrawal of those earnings. So, in effect, we get tax advantages two and three with Roths. The chart gives us a handy visual of which plans give us which advantages.
One of the things we need to keep in mind with these retirement plans is that they are intended to be retirement plans. There may be penalties if the money is withdrawn before your retirement years.
While I would love to walk through all the possible penalties and the exceptions, my goal isn’t to make this a dry book on tax law. Keep in mind that all of the details regarding plan access are available on the IRS website (irs.gov). I would tell you to do a simple search, but my experience is that many websites contain outdated information and advice that is just plain wrong. I’ve even run into instances where IRS employees gave bad information on tax consequences of early withdrawal. That is why I recommend sticking with their website.
Why all the confusion? Some plans have age 55 as a retirement year, some have 59 and a half, some plans allow loans, some don’t. Then there are hardship withdrawals, exceptions due to death or disability, 72(t) distributions, short term IRS rule changes . . .
phew, and that’s just the tip of the iceberg. Make sure you get good counsel before taking action on early withdrawals from these plans.
The power of tax deferral
One of the reasons these retirement plans are so popular is because of the ability to get tax advantage number two—tax deferral. This can be a great benefit because earnings, rather than being subjected to taxes every year, can be allowed to stay in the investments and compound until some later date.
To show the magnitude of this advantage, let’s assume an investment that has a linear 10% per year return. Linear just means that the return is the same every single year. That’s the approximate annualized return of the S&P 500 dating back to the 1920s. The stock market doesn’t move in this linear fashion, but we’re going to pretend it does for illustration purposes.
If you start with an investment of $100,000 and it grows for 30 years at 10% per year, your ending account value would be $1,744,940.
What if you had a 30% tax on gains each year? What effect would that have on your accumulation? That would, of course, net your return down to 7% per year. You might think that’s not a huge difference, but it may be much bigger than you think. Your accumulation actually comes down to just $761,226—nearly a million dollars less on a $100,000 investment.
Now think about how that affects your retirement income off of your investment. If you’re living off of 4% of the account value in retirement, then your income drops from $69,798 to just $30,449. That can be a big difference in the standard of living.
This is why deferring taxes on gains is such a popular idea and why that feature of retirement plans is so important. A slight percent loss in return adds up quickly over longer periods of time.
Would you like personal help with your financial plan? Schedule a call with us to explore what this can look like for you here.
Individual Retirement Accounts (IRAs) come in two basic forms that you may be familiar with. The first is the Traditional IRA. As we’ve discussed, this type of IRA allows a deduction in most cases for the contribution and tax deferral on gains during the accumulation stage.
There can be instances where the contribution isn’t deductible on a traditional IRA due to income and participation in work retirement plans. For instance, if you have a 401(k) at work and you’ve maxed out your contribution limits and want to also contribute to an IRA, you may not be able to deduct that contribution if your income exceeds certain levels. These thresholds change each year and can be found by a simple internet search or by asking a financial professional.
If the contribution to an IRA is not deductible, I typically recommend not making the contribution. There is one notable exception—the “back-door” Roth IRA, which will take a little explaining.
Back-door Roth IRA
As stated, an investor who wants to put money in an IRA above and beyond what they can put in work retirement plans may be prevented from deducting the contribution1. When that is the case, they may look into contributing to a Roth IRA instead. While Roths aren’t deductible, they do benefit from tax-deferred growth and tax-free income later on. There is a catch though. If your income is too high and you have a work retirement plan, you can’t contribute to a Roth. The threshold is much higher than the IRA deductibility threshold, but it’s not unlimited.
Enter the “back-door” Roth. You may be able to contribute to a non-deductible IRA and immediately convert it to a Roth. This works because there are no income limits on non-deductible IRAs and the old income limit that existed on Roth conversions has long been discontinued.
Now, this won’t work seamlessly if you have a pretax IRA, so make sure you run this by a financial planning professional before trying this strategy on your own. It has to do with an aggregating rule that you probably don’t want me explaining here. There are ways around it, but it is far too complex for this book. My goal is simply for you to be familiar with these strategies so you will know to ask about them during planning sessions.
Another instance where you may use a Traditional IRA is with rollovers from employer retirement plans. Let’s say that you’ve been laid off, or more happily, you’ve gotten a better job. You don’t have to leave your money in your old retirement plan in most cases. You may choose to “roll” your qualified plan into an IRA. This is often beneficial because work retirement plans often have limited fund choices and employers often spread plan costs out across all participants’ accounts. If you don’t work there anymore, there’s no need to help pay those costs.
You may have a large array of mutual funds and/or ETFs (Exchange Traded Funds) in your work retirement plan, but I have found that there are almost always market segments missing that really help to diversify the portfolio.
It may seem strange that large retirement plans would be so limiting, but there are logical reasons for this. For example, studies find that, given too many choices, people tend to freeze up and may be less likely to participate in a plan due to the confusion. For more information on this topic, read my book Confident Investing: Why Blind Trust is a Poor Investment Strategy.
Another benefit of IRAs (and other qualified retirement plans) is potential liability protection. In most states, IRA accounts are protected from the claims of creditors. This doesn’t include the IRS or long-term care expenses, but it can be a valuable advantage.
As we’ve discussed, Roth IRAs are also a popular retirement planning tool. With a Roth, we don’t get a deduction for the contributions to the account, but the earnings grow without taxes, and then in retirement you get to take the money out tax-free. In addition, the distributions aren’t counted for calculating taxes on Social Security. We’ll talk more about that later.
Here’s another neat advantage of Roth IRAs—the principal is always accessible without penalty. Normally when you pull money out of a retirement plan before the age of 59 and a half (55 with 401(k)s and similar qualified plans), you may have to pay a 10% penalty in addition to taxes on the distribution. That penalty can add up.
However, taxes with Roths are handled first-in/first-out. The first money to go in your Roth is the contribution. The last money to go in is the gains. If you put $20,000 in contributions to your Roth IRA and the current account balance is $45,000, you can pull that $20,000 at any time with no penalty. It’s just the gain that might be subject to penalties.
There are some penalty exceptions for first-time home buyers and some education expenses, as well as a five-year holding period rule you may need to consider, so make sure you know the rules before trying to withdraw gains. This stuff can be complicated!
Deciding between a Roth IRA and a Traditional IRA
I’m often asked how I decide between Roth contributions and deductible Traditional IRA contributions. This can be tricky, and it’s dependent on your specific situation, but hopefully, I can give you some tools to make wise decisions.
One of the considerations is your current tax rate versus the rate you will likely pay when withdrawing the money in retirement.
In America, we have what is called a graduated tax system. The first income you earn is not subjected to income taxes due to standard or itemized deductions. Once your income goes above the deduction amount, the tax rate is 10% on the next block of income. Above that, the rate goes to 12%, then the next block is taxed at 22%, then 24%, 32%, then 35%, and finally 37%. You may also have to pay state taxes on top of this.
If I’m in a 24% tax bracket, that simply means I will have to pay 24 cents on the next dollar I earn. If I’m contributing to a Traditional IRA and it’s deductible, I will avoid that tax.
An easy way to visualize the effect of the differences in current marginal rates and my future tax situation is to draw a chart. Here’s how to understand this chart.
If you have $1,000 in gross (before tax) income that you want to invest, you have two choices—Roth or Traditional. If you go Traditional, the whole $1,000 goes into the account. If you choose Roth and are in a 30% tax bracket, then you have to pay $300 in taxes and can put $700 in the Roth IRA.
Let’s say you had great investment returns and you multiply your money ten times over. You would now have an account value of $10,000 in the IRA, but your Roth IRA would only be $7,000 ($700 times 10). So that 30% in taxes paid upfront makes a big difference in the long-run.
In retirement, your income may be taxed at several different rates like it was when you were working—the first dollars at 0%, the next at 10%, then 12%, 22%, 24%, and so on. Your average tax rate would be a combination of those. To determine your average rate, you simply need to take your tax payment and divide it by your taxable income.
In my example, I’m assuming an 11% average rate. While you would pay no taxes on a Roth IRA upon withdrawal, you would owe taxes on the IRA. If the average rate is 11%, then the tax on your $10,000 is $1,100.
As you can see from the illustration, it is easy to compare the two choices. If you put $700 in the Roth, it is worth $7,000. If you put the full $1,000 in the IRA, avoided the tax on the contribution, and paid just 11% on the distribution, then your spendable money is $8,900 ($10,000 minus $1,100).
Here’s the point. If your average tax rate upon withdrawal is less than the rate avoided when the money was invested, then there is an advantage to taking the deduction upfront. If rates are higher down the line, then you should pay the taxes before investing.
This concept is often sold by using an illustration. Imagine a farmer who was given a choice: either pay taxes on the cost of your seed (which is cheap) or taxes on your harvest (which may be large). Which would you prefer? Most would say “pay tax on the seed.” As you can see from the above example, our graduated tax system reveals this analogy to be an oversimplification. But I wanted to include it because it is an illustration you may run into.
There is another complicated factor in making this decision. Withdrawals from traditional, tax-deferred retirement plans can create taxation on Social Security benefits. I will talk about that more later, but it is good to be aware of this concept. It’s often referred to as a “tax torpedo.” Not only can you have taxes levied on your Traditional IRA, but the money you withdraw out of the account can make Social Security—an otherwise tax-free income stream—taxable.
You may wonder how we keep track of all of this and make decisions. Some of the most valuable tools financial planners have at their disposal are complex financial planning programs that model various tax scenarios. These are a necessity with all of the variables we face. If you aren’t using these tools, you could be potentially costing yourself a fortune in taxes in retirement.
So, when does a Roth make sense?
Roth IRAs are often a good choice when the investor is very young, in a low tax bracket, and likely to see higher rates in the future.
As I alluded to earlier, they can also be a good choice when I’ve exhausted my ability to contribute to pre-tax retirement plans at work and can’t make deductible contributions to IRAs. Just as it makes sense to diversify with investment choices, it can also make a lot of sense to diversify from a tax standpoint.
If you are likely to receive a large inheritance that may drive your taxable income up in retirement, a Roth can help by not adding fuel to the fire.
Likewise, if you are fairly certain that you won’t need much of the money in your retirement accounts, and you have children who will likely inherit the money at a higher tax bracket than you are in, a Roth may make some sense.
There are a couple of risks to consider. If we move to a lower flat tax or a national sales tax, you may actually be sorry you paid taxes under the current tax regime, in an attempt to avoid lower future rates, only to end up getting hit with a tax on consumption. This has been the trend around the world and could happen here as well. Many see it as a “fairer” tax that catches revenue from people who are currently skirting the system by hiding income.
Another thing to be wary of is if the government figures out some indirect way to tax Roth distributions. Municipal bond income and Social Security income used to be free of taxes. Now, this income is taxable for many who never thought it would happen. For instance, at the time of writing this, Roth distributions aren’t counted when calculating Social Security taxation. That may change in the future when the government sees the potential to increase revenue.
As you can see, retirement plans can be full of complexity. The government has put an elaborate system together to incentivize Americans to save for their retirement, along with a complex set of rules. Our tax system is often used as a carrot to lead people to a desired behavior.
The ability to deduct contributions, defer taxes on gains, and potentially receive income without taxes is often sufficient to get people to put money away for their “future self.” Knowing what vehicles to use and how much to contribute and staying on top of the rules requires a good bit of strategic thinking as well as a good bit of creativity. As in many things in life, balance is often the key to getting good results.
By Paul Winkler
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*Advisory services offered through Paul Winkler, Inc. (‘PWI’), a Registered Investment Advisor. PWI does not provide tax or legal advice: please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase or sale of any securities. Information we provide on our website, and in our publications and social media, does not constitute a solicitation or offer to sell securities or investment advisory services, or a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.
1 Ask your plan administrator for plan contribution limits