Financial Planning Friday: Taxes, Now or Later?

June 10th, 2016 by Anchor Bay Capital's Investment Team

Did you know that the average person makes 6 to 10 financial decisions every day?

From simple shopping choices to major life transitions, we are constantly faced with the challenge of how to put our hard earned money to work in the best possible way.  As consumers, most of our decisions are preoccupied with immediate or short term needs and choices concerning our future are more easily put off for another day.  If you can take the time to pause and think long term for a moment, here is a choice that you can make today that will have a major impact on your future:  When will you pay taxes on your retirement savings?

A look at the history of taxes:

In 1978 there were 26 different tax brackets if you were Married Filing Jointly.  The highest marginal tax was 70% for a household making over $203,200.  Today we have 7 brackets with the highest rate being 39.6%.

I bring this up because by taking a look back we can gain perspective on our current tax environment and be a little more informed on how taxes may affect us in the future.

Where are taxes going from here?

We can’t really say.  It is an election year, and both of our remaining candidates are touting plans to provide tax relief for hard working families.  It is the stuff we all like to hear.  However, if we think logically about our current financial environment, there are some problems that we don’t like to hear. We do have an aging population with costs of entitlement programs like Social Security and Medicare that continue to grow.  We have a National debt that continually needs to be serviced.  We are in a period of historically low tax rates.  While nobody can definitely say how taxes will be different next year or 20 years from now, the more income our government requires, the more taxes will have to be modified.

Pay now or Pay Later?

If you are saving for retirement, chances are you are deciding to forego paying taxes now and choosing to pay them later.  The majority of company retirement plans allow you to save money from your paycheck before taxes are deducted.  I call this pre-tax money.  This lowers your taxable income today and gives you an immediate deduction.  This money goes into your account and is invested to grow over time.  As you lock in gains or earn interest on your investments within the account, the taxes you would normally pay on those gains are deferred until retirement.  You also may receive company contributions or matches that are deposited into your account without being taxed.  When you pull out your money it is now fully taxable as ordinary income because it has never been taxed previously.

Common pre-tax accounts:

• Pensions
• 401(k)’s
• Traditional and Rollover IRA’s
• 403(b)’s, etc.

Some retirement plans offer you the ability to make after-tax or Roth contributions.  In this situation you are choosing to pay taxes now instead of later.  This means that money goes into your account from your income after it has already been taxed.  In these types of accounts, your earnings within the account still grow tax-deferred.  At retirement everything can be withdrawn tax-free, so you have the added benefit of receiving the earnings on your contributions without ever being taxed on them.

After-tax accounts:

• Roth 401k’s and Roth IRA’s. (It should be noted that certain other financial vehicles like permanent life insurance can be structured to provide tax-deferral and tax-free access to your money. However these are not qualified retirement accounts)

Remember the 1978 taxes I mentioned earlier?  If I was saving for retirement back then, it would have made total sense to defer taxes by saving my money pre-tax and then withdrawing my money in retirement in a much lower tax bracket.  However, today that scenario is not the same.  Chances are most people will be in the same tax bracket or possibly higher in retirement.

Will Your Income Needs be Significantly Different in Retirement?

You may have an effective plan to reduce your living expenses, debt payments and healthcare costs in your later years, but have you considered strategies to reduce your future taxes?

Since you cannot control where tax rates are going in the future, building up a nest egg of after-tax assets allows you to control your taxable income in retirement.  By withdrawing tax-free income from these assets to supplement your taxable income you can effectively avoid moving into higher tax brackets purely based on the need to cover retirement expenses.

Pre-tax retirement savings may make sense if you need to lower your tax burden today.  Otherwise, you may want to consider building up a bucket of tax-free retirement savings that you can count on in the future.

 Key Items to Remember

• If you are getting a company matching contribution, take advantage of this money first.
• If you have a Roth contribution option, your company contributions are still pre-tax.
• Contribution limits vary depending on the type of plan. It is important to work with your advisor to optimize your contributions.