Do you remember the Cheshire Cat in the movie Alice in Wonderland? Alice asks the Cheshire Cat which way she ought to go. The Cheshire Cat responds, “Well that depends on where you want to get to.” Alice replies back, “It really doesn’t matter.” The Cheshire Cat’s propound response is, “Then it doesn’t really matter which way you go.”
When it comes to money or finances, this is a horrendous way to plan. You should absolutely know where you want to go and what it is going to take to get there. However, what I’ve seen over the last 16 years of my career as I’ve talked to clients from California to New York, is that many don’t know where they are going. They are simply setting money aside and hoping, crossing their fingers, that it’s going to work out in the end. More times than not, it doesn’t work out as they had thought.
Can you get to a zero percent tax bracket in retirement, or as close to that as possible?
Many believe that they will be in a lower tax bracket in retirement. However, consider that exemptions and deductions may not be as abundant as they were while working. For example, your home will probably be paid for in retirement; no more interest deduction. Your kids will be out of the house; no more dependent exemptions. Your charitable giving may not be as much because you are no longer working. Your qualified plan contributions have stopped; no more tax-deferral of those dollars.
Last but not least, what if taxes actually increase in the coming years?
Most people are taught to put money away in a 401(k) or an IRA and grow that money through their working years, for 20, 30, 40 years. At some point they retire.
Think of this as a climb up a mountain. This climb has a lot of rough terrain along the way; market losses, life issues, job losses, etc. This climb up the mountain is called the “Accumulation” phase of your life. The goal appears to be to get to the top of the mountain. At the top, we might call this retirement.
At 65 let’s say, you hit this point of retirement; the top of the mountain. Although this appeared to be the goal, it really isn’t. Once on top of the mountain, the issue then becomes coming down the mountain. The “Distribution” phase of your life.
Think of it like this. What if you went on a climb and your guide said to you, “I can get you to the top of the mountain, I’m just not so sure I can get you back down.” What are the chances or likelihood of you having that guide take you on that specific climb? Would you go? This is where a lot of people find themselves today. People are putting money away in a typical qualified plan; 401(k), 403(b), or IRA, and believe they are set. They hear from a financial planner or adviser the belief that they are accumulating wealth and growing their money, but then what? Getting down the mountain, the distribution phase of your life, can be dramatically more important.
How are you going to enjoy those assets that you accumulated over a lifetime? Now think about it. Why are you saving and investing money? Why are you told to have a certain net worth or nest egg to live on in retirement? The main reason is this: Income.
Future income is why people save and invest money. How can you get the maximum possible income in retirement?
On this mountain climb, the accumulation phase, what I hear often from clients is the question of, what is the rate of return that I’m going to get on that investment or that account? Yes, rate of return is important. However, it’s not always about the growth of your money, or the money you earn, it’s about the money you keep!
The other thing that comes into play here is the rampant advice given by many CPA’s, accountants, and financial advisers to put your money into accounts that are tax deferred. Some of these tax deferred accounts include 401(k)’s, IRA’s, and other Qualified Plans such as SEP’s, Simple’s, and profit sharing plans. Tax deferral has several unknown factors.
How much of the money that you put away will you actually get to keep? There are three ways your money can be tax-treated, they are: tax deferred, taxable, and tax free.
What does tax deferral really mean? It means kicking the tax can down the road. Let me be clear here. A tax deferral is not a tax savings. There are individuals out there that believe tax deferral is a tax saving. It’s not. It’s a deferral. The tax can is being kicked down the road to some unknown future tax rate.
Taxable accounts include CD’s, savings accounts, brokerage accounts, money market accounts, bonds, etc. You pay the tax at the end of the year on any gains.
Tax free accounts could include Roth IRA’s, municipal bonds, and life Insurance. You pay the tax on the money now at today’s historically low tax rates, then fund these accounts with after-tax dollars. The growth on these accounts, if funded correctly, comes to you tax free.
Let’s look at these three ways to be taxed in more detail and why someone might choose one over the other. We want to look at these three ways to be taxed as tax buckets.
The taxable bucket: Why might someone choose the taxable bucket? The answer is usually liquidity. It’s about access to cash. Also, there are those that choose taxable accounts because they don’t want the government involved in the long term tax implications of their savings or investments.
The tax deferred bucket: Why might someone choose the tax deferred bucket? Usually there is some form of an employer match on the contribution to the tax deferred plan. Many people view a match as free money. Another reason is that people believe that deferring the tax is saving them money. However, as mentioned above, that isn’t true.
Another benefit people see is that a 401(k) or IRA is like a forced savings. Money is coming out of a pay check every couple of weeks and that person is being forced in essence to save money.
Again, the problem with the tax deferred bucket is that at some point a tax will have to be paid, but how much, and exactly when is unknown.
Think of the tax deferral bucket as a partnership. The partnership involves you and the government. Why? Because they are giving a benefit on the tax deferral, yet you have to play by their rules.
Do you really want to be in a partnership with the government?
Here are the rules you must play by when in that partnership:
- Rule #1 – You have to contribute all the money.
- Rule #2 – You take 100% of the risk.
- Rule #3 – You relinquish control.
- Rule #4 – Your future tax outcome will be decided by the government.
Here’s an analogy. If you walked into a bank and asked for a loan and the loan officer said, “Sure, we’ll give you the loan, but we’ll tell you the stipulations of the loan later. Here’s the money, now sign the paperwork.” You might say, “Wait a minute, what’s the interest rate? How much is the monthly payment? When do I have to pay this back? What are the terms?” Chances are, you wouldn’t take the loan. Why? Because you have no idea what the future consequences will be.
Similarly the same can be said for tax deferred accounts. Ultimately, you don’t know what future taxes will be. The point is, you have no idea how those four rules are going to affect your future.
As you put money into a tax deferred account you need to be aware of a few things, those things include how the government historically has handled tax revenue. In 2012, for every dollar that the government received in tax revenue, 76% of it was spent on Social Security, Medicare, Medicaid and interest on the national debt. It’s projected that by 2020, 92% of every dollar collected in tax revenue will be spent on those four things.
The national debt alone is over 19 trillion dollars and it continuous to escalate day after day, year after year. You can view this in real-time at: www.usdebtclock.org.
Medicare, Medicaid, Social Security; the dollars to fund these programs, and many more programs, will more than likely continue to increase.
Social Security was first started in 1935. That was over 80 years ago. The average life expectancy in 1935 was 62 years old. The average retirement age was 65. Social Security in 1935 was not put in place for retirement. It was put in place as insurance in case someone happened to live beyond the age of 62.
There is tremendous pressure on Medicare and Medicaid. It is estimated that that these programs exceed 120 trillion dollars in unfunded liabilities. There are studies that show these numbers are even higher. How will these unfunded liabilities be paid for?
It’s projected that all tax revenue collected will go toward these entitlements and net interest on national debt by 2031. It’s been said that to solve the problem, one, taxes would have to increase by 50%, or two, the government has to lower spending by 50%.
Does it appear that the government is going to slow down any time soon with spending?
The US Marginal Tax Rate from 1913 to 2016 at the highest bracket has averaged 58%. As a matter of fact, for over 5 decades between 1930 and 1985 taxes in the highest marginal bracket were above 60%, and for 2 decades taxes were over 80%.
Here we are in 2016 at a highest marginal bracket of 39%. Are taxes going up or down in the future? No one knows for sure, but historically speaking, taxes today are on sale.
How will the government fund all the unfunded future liabilities? Potentially with future tax dollars, and what that could mean is decreased income for you in your retirement years.
Coming back to these three tax buckets, most Americans today are saving for their future, for their retirement, in the tax deferred bucket. As we’ve seen with these examples and the tremendous pressure of unfunded liabilities, tax deferral perhaps is not the best place to be saving for the future.
This brings us to the tax free bucket.
As mentioned earlier, the Roth IRA grows tax free. However, it’s still a government plan. There are restrictions on the amounts of money that can be contributed to a Roth IRA, and if your income exceeds a certain dollar amount you may not be able to contribute to a Roth IRA at all. There is still a 59 1/2 restriction on accessing the growth of the account without a 10% penalty. Usually the dollars in a Roth IRA are still tied to the stock market with volatility and unknowns regarding those investments.
“Muni” bonds or Municipal bonds are not truly tax free. If you are purchasing muni-bonds outside of your state you could still be subject to state income tax on those bonds. Municipal bond income is also added to provisional income, it’s not exempt, which means it could add to the amount of tax you pay on your Social Security.
Cash value life insurance is the most advantageous in the tax free bucket. Contributions can be unlimited. The focus is to structure the policy correctly so that the minimum amount of life insurance is purchased while maximizing the cash value growth of the life insurance policy; the focus is on cash value. I recommend to clients to minimize the death benefit and maximize the cash value. It keeps costs low and allows for true compound interest growth.
Here is what I mean by true compound interest. If you are making a stock market investment with mutual funds, stocks, a brokerage account, your 401(k) or IRA, whatever it may be, what you’ll notice is that the volatility of the stock market does not allow for consistency. You could lose your gains. You could lose your reinvested dividends. I’m trying to make the point here that the stock market is all over the place. You cannot have true compound interest in a system with volatility.
Cash value life insurance on the other hand is guaranteed to grow with true compound interest. There is no loss of money from one year to the next. Your cash value increases year after year. All the growth is able to be used by you now, and in your retirement years, 100% tax free.
Cash value life insurance has the most advantages in the tax free bucket.
If taxes double, or go up even slightly, when your money is in the tax free bucket, tax increases don’t impact this portion of your portfolio.
Remember the goal is income. Again, it’s not always about the money you make, it’s about the money you keep. As we look at the life insurance tax free bucket, it allows you to have tax free income in the future, growing at a guaranteed compound rate through the accumulation phase of your life. The goal is to maximize that tax free income in retirement.
As you understand more fully these three tax buckets, there are certain dollar amounts that should go into each bucket. Maximize your income and optimize your wealth with proper allocations to each of these buckets.
Change your financial future. Reallocate money from accounts that might always be taxed to accounts that are tax free.