Published January 13, 2015
This week, Gail urges you to factor taxes into your retirement withdrawals. It can be smart to mix up your accounts!
My wife and I are both contributing the maximum amounts allowed by law to our tax-deferred investments. She has a 403(b) and I have a 457 plan. Since we are both turning 50 this year, we are eligible for the catch-up provision, which allows us to invest an additional $4,000. In all, we will each be contributing $18,000 to our employer plans this year.
In addition, we are both contributing the maximum into our Roth IRA accounts.
We expect to continue working another 10 years before retiring.
When we retire, most of our investments will be in tax-deferred accounts. This means we will have to pay taxes on our withdrawals.
I know that the advantage of tax-deferred savings is that some of the money that is working for us now would have been lost to taxes otherwise, so I'm sure that investing the maximum allowed is a smart move.
However, is it possible to have too much of our investments in tax-deferred accounts?
I know that most people will be in a lower tax bracket when they are retired and start withdrawing, but that may not be the case with us. I’m concerned we may end up paying more taxes on it when we take it out than we would have paid today.
Do you think it is wise for us to put so much of our money into tax deferred accounts or would it be better if we put more of it into accounts that won't hit us so hard with taxes when we withdraw?
Dear John —
I am totally awed that you and your wife are managing to salt away a whopping $45,000 this year! ($36,000 in your employer plans plus $4,500 apiece in your IRAs.)
Though you don’t specify this, your (modified) adjusted gross income must be under $150,000 or you wouldn’t qualify for a Roth IRA. So $45,000 represents at least 30 percent of your income. Perhaps your home is mortgage-free, your kids have all moved out, you never buy expensive cars, or take fancy vacations. In other words, you don’t miss this money. I find myself in the unique position of advising that you not excessively deprive yourselves of current income because you feel compelled to max out your retirement plans.
I must say, your dilemma is unusual. Most people are happy to scrape together enough money to make any contribution to a retirement plan, while the two of you are maxing out and wondering if you are putting too much into these accounts.
Unfortunately, there is no simple answer. The problem is, all of this hinges on what income tax rates will look like in ten years when you retire and start withdrawing money to supplement your income. I wish there were a crystal ball that could tell us what Congress will do on that score, but we both know how unpredictable that is.
Don Sowa, a veteran financial planner with his own firm in Providence, R.I., says that, while you might not relish the thought of paying taxes on this money later, you need to ask yourself how important is the tax deduction you are getting today on your contributions to your company plans.
Based on the information you have given, I estimate that you are in the 28-percent tax bracket. That means you and your wife will save $10,080 in federal income taxes alone this year on the $36,000 you are contributing to your 403(b) and 457 plans. If you put less into these plans, you can count on paying more income tax. This will reduce what you can invest outside your plans.
In other words, say you cut your company contributions to $10,000, putting a total of $20,000 into your plans. That leaves you with $16,000 more income. From this, subtract $4,480 in federal taxes (plus whatever state taxes you would owe), leaving you roughly $11,520 to invest on an after-tax basis.
The point is, if you direct your retirement dollars into after-tax investments, you’ll have fewer dollars available to invest today. That’s not necessarily good or bad. Just a fact.
Another issue is, how much do you already have in your retirement plans? If the $18,000 you are each contributing this year is the first money you have put into these plans, that’s a much different situation than if you already have sizable balances.
But instead of trying to guess what politicians might or might not do (a sure recipe for frustration), Sowa says a better approach would be to start with the future and work back to the present.
Think of it this way: Once you are retired, what will be your “dependable” sources of income? These would include Social Security, annuities, income from a defined benefit pension that either or both of you might be entitled to. Add up all the income streams that are — as best as can be — guaranteed.
Then come up with a rough estimate of how much money you are going to need to live on. (It’s probably easiest to think of this in monthly terms.) The difference between your “dependable” income sources and your required income represents the amount of money you will need to withdraw from your other “pots” of assets.
Essentially, at retirement you’ll have three pots of assets: 1) qualified (tax-deferred) accounts such as your wife’s 403(b) and your 457 plan, which will probably be rolled into traditional IRAs; 2) your tax-free Roth IRAs; and 3) taxable investments such as bank and brokerage accounts. Together, these represent what Sowa calls your “money machine.” The question is, he says, “How big a job does the machine have to do?”
For instance, imagine you retire today. How much monthly income would you need? For argument’s sake, let’s say it’s $4,000.
In 10 years, based on an annualized inflation rate of 3 percent, that income need will have grown to nearly $5,400. On a visit to the Social Security Web site: http://ssa.gov/OACT/ANYPIA/ you quickly learn that the monthly Social Security checks you and your wife will receive should total $2,300.
That tells you that your “money machine” will have to crank out $3,100/month to meet your expenses. That works out to $37,200 worth of withdrawals in your first year of retirement.
Don’t make the mistake of stopping there.
I have software professional planners use called “Financial Profiles,” http://www.profiles.com , which is very useful in making projections. I plugged some basic assumptions into the program such as that the two of you will start retirement at age 66, that you’ll both live to age 90, and that inflation will run 3 percent a year for your entire retirement — which may be low, considering medical costs represent a big part of a retiree’s budget and that these have been increasing at a higher rate than inflation in general. Each year, in order to maintain your lifestyle you take out 3 percent more income than the year before. I also figured you wouldn’t want to take a lot of risk with your investments, so I assumed a 6 percent annualized rate of return on your portfolio. Lastly, because I needed to fill in the blank, I said your wife’s name was “Sally.”
How big a nest egg would the above scenario require? $637,177.
The chart below from Financial Profiles illustrates why a “little” number like 3 percent can be deadly. In order for your income to keep up with inflation, in your tenth year of retirement, your withdrawals will have to increase to nearly $50,000. By the time you are in your mid-80s, your “money machine” will have to be producing twice as much income as it did in Year #1.
A “little” number like 3 percent can be deadly. In order for your income to keep up with inflation, in your tenth year of retirement, your withdrawals will have to increase to nearly $50,000. By the time you are in your mid-80s, your “money machine” will have to be producing twice as much income as it did in Year #1.
I recognize this example doesn’t tell you anything about whether this is the right “mix” of taxable vs. tax-deferred vs. tax-free investments. Frankly, it’s impossible to know this without having more details about you and your expectations about future tax rates. But this should give you an idea of whether you and your wife need to save as much as you are. What you really ought to do is have an experienced financial planner run the real numbers for your specific situation.
Sowa thinks you are right to question whether you might have too much in tax-deferred plans. He says when people do retirement planning they are often so focused on saving enough money they don’t consider the tax consequences, that is, [where] to save that money. We are both big fans of Roth IRAs, which, as you know, only accept after-tax contributions, have no required withdrawals no matter what your age, and when you do take money out, it’s always tax-free (provided you follow the rules).
“You need to look at what are the most efficient vehicles for saving your money,” says Sowa. ‘If your employer is matching your contributions to your plan, be sure you fund it enough to receive the maximum match. “ Next, assuming that reducing your current taxes isn’t as big a concern as the taxes you might have to pay on withdrawals in the future, fund your Roth IRAs to the fullest extent allowed by law. (Considering the catch-up provisions, next year and in 2007, you’ll be able to put $5,000 into an IRA.)
If you have money available beyond these amounts, Sowa says he would consider putting it into taxable accounts where “a large part of the money withdrawn would probably be taxed at the lower, long-term capital gains rates.” (Even if tax rates revert to their former levels, long-term capital gains rates will still be lower than ordinary income tax rates.) He suggests tax-efficient stock mutual funds or individual blue chip stocks because, except for the dividends you receive, there are no taxes until your shares are sold.
Having your money in different “pots” with different tax consequences gives you options. “If all of your money is in your 401(k),” says Sowa, you have got no choice” when it comes to where you are going to take your retirement income from.
You never know: Congress might just shock us all and reduce the income tax rates even further! (I’m not holding my breath.)
Hope this helps,
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