After you have figured out what you need to retire, there are three ways to get there. You can invest in solutions that are tax-free, taxable, and tax-deferred. Tax-free means you pay tax up front and withdraw the money tax-free. Taxable means you pay tax whenever you sell the investment or get income from it. Tax deferred means you don’t pay taxes now and you will pay it when you withdraw it later. Taxes are our largest expense for most people over their lifetimes. That comes as a shock to our clients. Diversifying how you pay your taxes in retirement is a good strategy, since future tax rates are unknowable.
Many of us happily assume that how we get to retirement, and how we withdraw our funds lead to the same solution. That is sadly incorrect. It depends on the tax rate now, what the tax rate is when you retire, and what sources you tap as you move through retirement. It’s a common assumption that our tax rates will be lower when we retire. We forget we’ll lose many of our exemptions, no child tax credit, no retirement contributions, no deduction of mortgage interest or student loans. We will need to keep up with inflation and greater medical costs, which will increase the amounts we need for retirement, and result in higher taxes paid.
Let me provide you with a simple example. Three friends, T, A, and S, each invest $1000 at the start of the year, in an investment that pays 6% income after every year. All income is reinvested after paying taxes. They hold the investment for 20 years. The tax rate is 20% now and in the future. T will invest in a tax-free account, A in an account that pays annual taxes, and S in a tax-deferred account. Who is better off after 20 years?
| T (tax-free) | A (pays taxes every year) | S (tax-deferred) | |
| Starting Value | $1000 | $1000 | $1000 |
| After tax starting amount | $800 | $1000 | $1000 |
| Growth after 20 years | $2,565.71 | $2,554.03 | $3,207.14 |
| After tax ending amount | $2,565.71 | $2,554.03 | $2,765.71 |
Friend T gets off to a rough start, having to pay 20% right away and not able to catch up. Friend S looks like a winner all the way through. She pays 20% of her gains after 20 years ($3,207.14 minus $1000 gives us $2,207.14 in gains, and 20% of that is $441.43 taxes paid). Friend A gets off to a fast start, and stumbles at the final amount. Paying taxes every year means less of her money is able to grow, and she ends up worse than friend T and friend S. Winner: Friend S.
Let’s change it up. It’s very optimistic to think taxes won’t change or get worse. What happens if state and federal taxes double after the first year and stay that way? We’ll start with 20% taxes, and double the taxes after the first year to 40%.
| T (tax-free) | A (pays taxes every year) | S (tax-deferred) | |
| Starting Value | $1000 | $1000 | $1000 |
| After tax starting amount | $800 | $1000 | $1000 |
| Growth after 20 years | $2,565.71 | $2,028.59 | $3,207.14 |
| After tax ending amount | $2,565.71 | $2,028.59 | $2,324.28 |
We start out the same way is before. Friend A gets punished, with her money only doubling once over 20 years. Friend S starts out well, but since she has to pay 40% on her gains, she gets punished at the end too, but slightly better than Friend A. Friend T is the winner here, who opted to pay 20% and avoid the whole tax increase fiasco. Winner: Friend T.
Suppose taxes have gone down after 20 years? We can’t rule it out, as that happened over the last 20 years in the USA. After the first year, taxes go from 20% to 10% and stay there.
| T (tax-free) | A (pays taxes every year) | S (tax-deferred) | |
| Starting Value | $1000 | $1000 | $1000 |
| After tax starting amount | $800 | $1000 | $1000 |
| Growth after 20 years | $2,565.71 | $2,862.94 | $3,207.14 |
| After tax ending amount | $2,565.71 | $2,862.94 | $2,986.42 |
Friend A does much better in this scenario. Friend S stays on top. Friend T, who opted to pay taxes up front, loses out on the lower tax rates. Winner: Friend S.
A question might be asked, why would you want to be Friend A? In every situation, she loses. In real life, Friend A will seek a higher rate of return, because she is taking on more risk with the higher taxes due. If we earn a higher return increases above the taxes paid, we can see how that’s a winner. Ask everyone who owns a Robinhood account why they invest in taxable accounts instead of the other two.
Your goals and retirement are very real, and the decisions you make now between the three tax options will impact your future later in life.
It’s fun and games here, since it’s all made up. Your goals and retirement are very real, and the decisions you make now between the three tax options will impact your future later in life. You have the benefit of time when you are young, but later time switches from friend to foe. Here, the entire amount is taken out after 20 years and subject to taxes. In real life, you have to work to minimize your taxes, every year and even after you die. More than 95% of clients we meet have their money in the tax-deferred buckets (own a house, IRA’s, and 401k’s) and taxable buckets (cash, stocks, mutual funds, ETF’s, crypto currencies), and almost none in tax-free buckets. That’s a mistake. Beneficiaries will pay high taxes if large money is in taxable or tax-deferred buckets when you die. Dying stinks. It is traumatic and emotional for our loved ones. Yet, it is inevitable. The prudent person has to consider what happens afterwards to the money they have worked so hard to earn and grow. Give more to their families or more to the government? That should be easy to answer.
We did two things to increase our exposure to the tax-free bucket. If you work with a large employer, many have the options for Roth 401k’s. We made the change of switching between a Traditional 401k to a Roth 401k for new investments. If your income is low enough, Roth IRA’s are a great option. I recommend starting them as soon as you are eligible for yourself, spouse, or kids. If you are able to take advantage of Roth 401k’s at work, you can switch your Roth 401k into a Roth IRA when you leave your employer. The second option we started is having an indexed universal life policy. Life Insurance premiums are paid after tax, growth is tax-deferred, and loans from an indexed universal life insurance policy cash value are usually tax-free (if done correctly).
If you have a high deductible health plan, investing money in a Health Savings Account (HSA) towards medical expenses is the best tax deal you can get. You get a deduction on your taxes upfront, the money grows tax-deferred, and when used for qualified medical expenses, the withdrawals are tax-free. In our situation, due to prior medical conditions, this doesn’t work for us.
I don’t know how it is in other countries, but the combination of taxes and investment options in the USA makes things complicated. None of the buckets are good or bad once you understand the purpose of each one. To repeat what we started with: Diversifying how you pay your taxes in retirement is a good strategy, since future tax rates are unknowable. It reduces your tax risk and has the chance to increase your returns.
DISCLAIMER: FOR EDUCATION PURPOSES ONLY. WE DO NOT PROVIDE INVESTMENT, LEGAL OR TAX ADVICE. PLEASE MEET WITH A QUALIFIED INVESTMENT, LEGAL OR TAX PROFESSIONALS FOR ASSISTANCE.
Sign up for when we publish our next post.
Thanks for reading!
Warmest regards,
smilingdad
smilingdad 