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This is an article in an occasional series on personal finance. Each article will address a different aspect of personal finances and provide some tips for you. However, always consult your own financial adviser or tax professional for your specific situation.
There’s been a lot of news about it recently, but not in the way most people think. For many retirement savers, diversification usually means how much to put into stocks, bonds, cash, and other assets. Chances are you took a risk tolerance questionnaire and based on your answers, you were given a model portfolio of how much you should put into the different investment categories.
The point of diversification is to reduce risk and theoretically lead to greater long term value. When one thing zigs, the other zags.
You likely haven’t thought about diversification the way it’s been discussed in the news. Most people don’t, yet it is equally important as types of investments.
What’s been in the news? Tax reform and the “Rothification” of 401k contributions. While Roth 401ks already exist, the federal government has proposed changing the way your retirement plan contributions are taxed.
Please note that this is not an article either for or against the idea. Rather, this is meant to discuss the potential of how it may impact your retirement savings, and the unintended potential benefit. And how you may want to change the way you save regardless.
The news is that some of your 401k contributions may be on an after-tax basis, much like Roth 401k/IRA contributions today. Put simply, you pay taxes on the money first in exchange for tax free withdrawals later. This is the opposite of traditional 401k/IRA contributions today, where you get a tax deduction today, but pay taxes later on withdrawals.
[Note: While this article was being written, the federal government has proposed a tax reform package that does not change how 401k contributions are treated. Still, the concepts in this article are relevant and the prospect of changes still exist.]
Why would the government do this? Because it’s money they can tax and get today, versus waiting until you are retired. Deductible retirement plan contributions fall under the category of a “tax expenditure.” Other common tax expenditures include mortgage interest deductions, state and local tax deductions, not counting employer paid health insurance premiums as income.
In fact, 401k contributions ranks sixth on the list of biggest tax expenditures estimated for 2018. Deductible 401k contributions will cost the federal government almost $70 billion in 2018, according to Department of Treasury figures.
Why is this news important to retirement savers? Because it would force tax diversification. And that can help your money last a lot longer.
By having a tax free source of income, you gain flexibility in retirement and can take advantage of how the IRS defines “income.” Roth 401k/IRA contributions, loan proceeds from mortgages/reverse mortgages, and withdrawals/loans from cash value life insurance are all sources of tax free income.
How can tax diversification help?
Lower withdrawal rate – For example, if you need to have $10,000 to pay a bill, you would need to withdraw $13,333 from a traditional 401k in order to net $10,000 after taxes, assuming a 25% tax bracket. But in a Roth, you only need to take out $10,000 since there would be no taxes due. By not having to withdraw extra for taxes, you can take out less and have your retirement money last longer.
Avoid other taxes – by having to take out more money for taxes, retirees can unintentionally step over the Social Security tax torpedo (yes, it’s really called that) line. If your other income is greater than certain thresholds, your Social Security benefits become taxable. For married filing jointly households, the first threshold is a $32,000 in modified adjusted gross income.
Avoid other costs – having too much other income can also trigger higher Medicare premiums. The first threshold for Medicare results in a 40 percent increase in cost. For the highest earners, the increase is 320 percent.
These increases cause a vicious cycle – take out money, taxes go up, take out more money, Medicare premiums go up, take out more money, etc. And your money disappears a lot faster than you thought it would.
There is one risk that all savers can’t ignore – public policy changes. Administrations of both parties have tried, sometimes successfully, made changes to laws that directly impact your finances. Whether this tax reform package goes through now doesn’t mean something else won’t change down the road.
By being diversified, you would have the ability to respond to changes and can manage your savings to last years longer than without being diversified.
A family I met with recently had a lot of savings in traditional 401k/IRA accounts. I told them that they have a lot of hammers, but nothing else in their toolkit. After some funny looks, I told them that when (not if) something needed fixing in their home, they better hope it required a hammer because they had nothing else. No wrenches, pliers, or screwdrivers.
In retirement, we all will have something needing fixing. The recent news has shed light on an issue that most don’t think about as a retirement savings issue. This family only had one tool – a 401k – and wasn’t tax diversified.
How many tools do you have in your toolkit?
Any views and opinions expressed a guest column are not necessarily those of WestfordCAT nor is WestfordCAT responsible for its content.