In a recent discussion with my accountant, we talked about my family’s retirement accounts and long-term investing goals. We both came to the conclusion we should focus on adding more to our taxable investments. We already have a sizable nest egg in retirement accounts.
Though I don’t plan on formally retiring really ever, it is possible to be lopsided and have too much in retirement accounts and not enough in taxable investments. With retirement accounts it’s possible you are saving money on taxes now, only to get walloped with a bigger tax bill in the future.
I certainly believe investing to be tax efficient is critical. Though at the end of my post on the subject, I also said “Keep in mind like any part of investing, one should not invest solely for tax avoidance.”
Most personal finance books say you should put away the maximum possible in retirement accounts. What they don’t talk about is when you have to start withdrawing money from your retirement accounts. They only talk about the accumulation phase, and all state your expenses are lower after you retire. Another Suze Orman type financial advice that doesn’t always apply to everyone.
Yes, income from a salaried position decreases but keep in mind for tax purposes distributions from retirement accounts (except Roth accounts) are taxed at ordinary income rates. It’s possible your tax rate is much higher when you retire.
Tax-deferred accounts does NOT mean tax avoidance.
I Have to Pay More in Taxes When I Retire?!?
Let’s use a hypothetical to show what I mean. Let’s say you currently have $1 million saved for retirement at 40 years of age. A lot of money for that age, but not an impossible goal. Especially if you are a married couple and you start saving for retirement right out of college. You don’t plan on retiring until at least 60 years of age, so you have 20 more years of investing with your retirement account. Assuming a 7% rate of return, and socking away an additional $25k annually, you’ll have approximately $4,500,000 by that time.
The problem is two-fold with retirement accounts: you have minimum required distributions starting at age 70 1/2, and any money you do take out is taxed at ordinary income rates. Currently long term capital gains and dividends are taxed at a lower rate than regular income. While this may change in the future, historically investment taxes are at a lower rate than income taxes.
So let’s assume you take out 4% annually from that retirement account, or $180,000. At today’s tax rates, that puts you in the 28% tax bracket. Obviously this isn’t counting for inflation, so let’s use the next lower tax bracket of 25%. That’s still higher than if it were all investment income and/or dividends in a taxable account – currently taxed at 15%. In other words, $18,000 more in your pocket annually if it were in a taxable account. So while you save taxes when socking away this money, it’s possible you lose this advantage when you start taking it out. Especially if you need large sums of money in any tax calendar year. With state taxes included, it can be as high as a 50% total tax rate. Ouch!
Obviously, if you are going to invest in taxable accounts, you should only use tax efficient investments, but they can be part of your total asset allocation. That means NOT using investments like REITS, bond funds, or dividend paying stocks (if possible). ETFs like Vanguard’s Russell 3000 Index ETF (VTHR), which cover the entire market, are pretty tax efficient. There are other funds that are specifically designed to minimize taxes as well, but also to track various indexes. These are perfect investments to place within taxable accounts. What you are setting up is a blend of tax deferred and taxable accounts.
Disadvantages of Retirement Accounts
- Retirement accounts are much more restrictive – By most situations you can only start withdrawing from them when you are 59 1/2 years old (55 in some situations). If you need the funds sooner, be prepared to pay a massive penalty.
- Assumes you are in a lower tax bracket when you retire. While this might be true for most people, it’s not for everyone. Retirement accounts are taxed at regular income levels. As we all know, tax rates are going up and are not expected to go down for the foreseeable future.
- Restricted investment selection – I, for example, love real estate rental properties. While it’s possible to invest in real estate with a self directed IRA account, I don’t consider that a viable option. Also, many retirement accounts have a poor selection of funds to choose from.
- Required distributions – With the exception of Roth accounts, you are required to take money out of your retirement account starting at 70 1/2.
- Taxed at ordinary income rates – This is perhaps the killer if you only put money into a retirement account. You are taxed at ordinary income rates. Depending upon other sources of retirement income and amount saved, it’s possible you are in a higher tax bracket than before retirement. Also taxes in the future are an unknown.
Bottom line: It makes sense to have a mixture of tax deferred and taxable accounts. It gives you much more flexibility when you retire. So while it makes sense to minimize your taxes while saving for your retirement, you should also be concerned after you retire. Obviously I’m not suggesting stop putting money into your retirement account, especially if your company does matching.
What I am suggesting is once you get past some level of retirement savings, you may want to balance it more out with taxable investments as well. With taxable accounts you have not only more flexibility with investments, their intended use, more control over when you have to pay taxes, and traditionally at a lower tax rate to boot!