by Eric Biddle
If you were to have a bucket with several holes the size of a pea you’d probably find a way to either fix it or replace it. Can you imagine the frustration of filling this bucket with a hose on the backside of your house only to lose a third of the water by the time you make it to the side of the house where the water is needed? This would be a terribly inefficient use of your water and your time. I recently had a bucket with a crack in the bottom and I decided it was worth the expense to pitch it and buy a new one.
Now, imagine that this leaky bucket is your retirement savings and you are trying to make it from here to the end of your life with a retirement vehicle that is tax-inefficient. Would you want to know there were other options? Would it be worth a small expense now to replace the old bucket and start saving smarter?
The retirement savings vehicle of choice for most Americans is a Traditional 401(k), Traditional 403(b), or a Traditional IRA. However, for most this is probably not the best choice. The logic for saving in one of these vehicles goes like this, “You are probably making more now than you will be during retirement and therefore you will be in a lower tax bracket during retirement.” This statement is true but it does not take into consideration the fact that 1. Income taxes are at historically low rates and most people you’ll ask believe tax rates will go up. 2. The earnings within a Roth 401(k) or Roth IRA will never be taxed. 3. You will not be forced to take Required Minimum Distributions from a Roth IRA. 4. Any money passed onto your heirs within a Traditional 401(k) or Traditional IRA will be taxed at the heirs’ tax rates while non-qualified investments, Roth money, and life insurance will be passed on tax free. Is it time to consider buying a new bucket?
Allow me to give brief summaries of some different tax-benefited strategies that may be more efficient for you. Of course, many of these strategies have complex rules surrounding them and should not be tried without consulting your financial planner.
Roth 401(k), Roth 403(b), and Roth IRA
The first strategy that most should consider would be to begin contributing to a Roth retirement savings vehicle. When we save to a Roth we are contributing post-tax. This means we are paying taxes on our money before we put it into the Roth which is the exact opposite of saving the money “pre-tax” in a Traditional retirement account. Here’s the difference illustrated in a very simplified way: Let’s say you put $5,000 into an IRA pre-tax and it grows to $40,000 by the time you retire. Congrats! You saved paying taxes on $5,000 worth of income and you are rewarded by paying taxes on $40,000 in income later during retirement. The other option is to put $5,000 into a post-tax Roth option, you pay taxes on the $5,000 but if it grows to $40,000 you will not owe a dime in taxes when you take it out. Would you rather pay taxes on $5,000 now or $40,000 later?
But aren’t there income limits for those contributing to a Roth IRA so that the affluent cannot benefit from a Roth strategy? Yes and no. First, there are no income limits which would prohibit one from contributing to a Roth 401(k) or Roth 403(b). There are income limits which would prohibit some from contributing directly to a Roth IRA but there is a loophole. There is nothing that prohibits one from contributing to a traditional IRA and then converting the IRA to a Roth IRA the next day. This is called a backdoor Roth.
Most people know that a death benefit from a life insurance policy is tax-free (estate tax being the exception.) Therefore, if you want to pass tax free money down to your heirs, purchase life insurance with after-tax dollars and give your heirs a post mortem present.
What most people don’t know is that by “over-funding" a cash value universal life insurance policy in it’s early years and allowing the cash value to grow, you can access the cash-value through loan-provisions without the need to pay taxes. The best part is that some policies will lock in a loan rate (which is a good idea while we are in a low interest-rate environment) and they will allow the money you’ve loaned yourself to still be participating in the growth of the account. While this deal sounds amazing, let me temper your enthusiasm. 1. It makes the most sense to use this strategy once you are already contributing as much as you can to Roth accounts. 2. Watch out for life insurance salesmen who want to sell you the biggest policy when you really want to buy the policy that you can afford to pack cash into within the first five years. 3. There is still a cost for the life insurance premium which will diminish the cash value.
Standard Investment Account
Sometimes a good old-fashioned, no bells and whistles, individual or joint investment account will get the job done in a more tax-efficient manner than a Traditional retirement account. Read that again just to make sure you saw it correctly. Here’s how a standard investment account works: You put money in post-tax but as you sell the investments within your account, assuming you are holding the investment for more than a year, you are paying long-term capital gains taxes which tend to be lower than the ordinary income tax you would pay when you withdraw the money from a Traditional Retirement account.
Furthermore, when you pass down investments within a standard account to heirs, they will receive what is called a “stepped-up basis.” What this means is that if you bought an investment with $5,000 in cash and it grows to $40,000, when you pass, your beneficiaries will not have to pay capital gains tax on the $35,000 of growth. Instead, they receive a “stepped- up basis” which means they now own the investment and it’s as if they purchased it for $40,000. The heir would only have to pay capital gains taxes on the growth above $40,000.
How’s Your Bucket?
The summaries of the strategies above have many IRS rules surrounding them. You really need to speak to a financial planner to understand how these strategies can be tailored to your financial life. It costs money to have a financial plan done by a true planner but the tax-savings from an efficient plan will likely far surpass the cost of the plan. Is it time for a new bucket?