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Tax Diversification Can Inoculate Retirees Against ‘Tax Paralysis’

June 25, 2015
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By Jarrett B. Topel

Learn more about Jarrett on NerdWallet’s Ask an Advisor

I’ve never understood why there exists in most Americans’ minds such a negative association with paying taxes (as in “death and…”). Doesn’t the fact that a person has to pay taxes mean that he or she has made money?

I get that there are any number of specific objections people may have, depending on their political or socioeconomic position, to how much they are taxed, or to what the money is used for. But it strikes me as odd that a signal of something relatively positive (having income worth taxing) can carry such a negative connotation in most people’s minds.

Taking it one step further, some even view paying taxes as a kind of penalty. For many retirees who have spent years contributing to tax-advantaged savings plans and now must pay the piper as they withdraw money, it can cause a negative emotional response we call “tax paralysis.”

Paying taxes isn’t punishment

A recent experience with a new client illustrates the problem.

Joe and Rhonda worked for many years, and having done their research, they followed the conventional wisdom and saved for their retirement using mostly tax-qualified and tax-deferred accounts (traditional IRAs, 401(k) and 403(b) accounts, and so forth). In doing so, they received an upfront tax deduction when they contributed to their accounts, and enjoyed tax deferral all along the way.

Now Rhonda and Joe are both over age 60 and recently retired, and they’re using the money they so diligently saved to enjoy their well-deserved retirement. At their last appointment, they told me that they would like to take the whole family (children and grandchildren) on an Alaskan cruise. The cost for the trip would be $25,000, so I explained that we would need to take out closer to $42,000 from their retirement accounts to cover the cost of the trip plus the federal and state taxes on the withdrawal.

According to their financial plan, they could certainly afford it without derailing their retirement goals, but when they heard this, they became extremely discouraged. They felt as if they were being “punished” for removing money from their retirement accounts. They ended up putting off the trip and continued to let money accumulate in their accounts, despite my repeated assurances that they could easily afford the trip. The result, of course, is that now they are not enjoying the money they have spent a lifetime accumulating, and they won’t allow themselves to have the invaluable experience of traveling with their family, and creating beautiful memories for everyone.

The psychology at work here, in our experience, is an all-too-common phenomenon that we expect to encounter more and more as millions of baby boomers make their way into retirement.

There are a few ways to address “tax paralysis.” One is to adjust one’s thinking around savings and taxes. Understand that putting money into tax-advantaged accounts is not a way of avoiding taxes, but rather a way of deferring them. A good way to start is with a change in mindset — to get away from the idea that paying taxes on money that has never been taxed before is some sort of a “penalty.”

Addressing the psychology around tax paralysis is often the only tool we have with clients who are already retired. But for those still saving, there are some concrete steps we can take to mitigate the effects of taxation in retirement. The most important of these is based on what we call the “Tax Triangle.”

The three sides of the triangle

Simply put, the Tax Triangle is a way to diversify a client’s investment dollars in different types of accounts, so that not every dollar withdrawn in retirement is taxed at the client’s maximum rate. As the name implies, a properly implemented Tax Triangle has three parts:

  • Qualified accounts
  • Non-qualified accounts
  • Tax-free accounts

Qualified accounts

To encourage American workers to save for their own retirement, the government offers the dual incentives of a current tax deduction and tax deferral along the way for money saved in certain types of retirement accounts, known as qualified accounts. The most common of these is the 401(k), but there are others, including traditional IRAs, 403(b) plans, SEP IRAs and more. Workers can take a federal (and often state) tax deduction for contributions to such accounts, saving money upfront. Tax deferral in these accounts means that no taxes are due on any earnings in the account (dividends, interest and capital gains) until funds are withdrawn.

Since those earnings can also generate income, the account can grow more quickly than it would if money needed to be withdrawn to pay the tax due each year. This is the reason most workers believe qualified savings vehicles are the best places to save for retirement, and why so many have the vast majority of their retirement savings in such accounts.

To get this tax-deferred growth, though, investors generally give up the right to take money out of the account before age 59½. If they do withdraw early, they will likely owe whatever ordinary federal and state income tax is due, plus a 10% federal penalty and possibly state-imposed penalties as well. (There are some exceptions to the early-withdrawal penalties).

The common misconception is that these types of accounts are “tax-free.” They are not. (There are no free lunches when it comes to taxes.) Instead, taxes are due when the money is withdrawn from the accounts, usually in retirement. Additionally, these funds are usually taxed at the investor’s highest ordinary income tax rate — as high as 39.6% for federal tax, plus whatever their state adds on. In other words, no taxes upfront, but taxes later on.

The conventional wisdom is that once workers are retired, they will be in a lower tax bracket than when they were working, and that will result in tax savings. This is not always the case, however — and when it isn’t, it often results in “tax paralysis” in retirement.

Non-qualified accounts

Non-qualified accounts are those that do not receive any special tax treatment. People often use these types of accounts only as a last resort because they believe that putting as much as possible in qualified accounts is always their best option for the reasons already discussed.

Non-qualified accounts, despite not providing any current tax deduction or ongoing tax deferral, do offer some advantages. When funds are withdrawn from these accounts, only the gains are taxed (plus, any losses can often be written off), and the gains are taxed at the more favorable capital gains rates (not ordinary income tax rates). Federal capital gains rates (currently topping out at 20%) are much lower than federal marginal income tax rates (currently as high as 39.6%). Additionally, there are no penalties for withdrawing funds from a non-qualified account prior to age 59½.

Tax-free accounts

The third leg of the Tax Triangle is made up of potentially tax-free investments. The most common type of account in this category is the Roth IRA. When using a Roth IRA, investors do not receive any upfront tax deduction, but they do get the advantage of tax deferral, and, if managed correctly, the funds can be withdrawn completely tax-free in retirement.

The triangle in action

Here’s an example of the Tax Triangle at work.

Say we have a retired couple who need to take $60,000/year from their accounts to provide for their retirement income. Under current tax rates, they could take $37,000 from their qualified accounts, bringing them up to the top of the 15% marginal tax bracket. The next $15,000 could be taken from their non-qualified account, where they would pay a flat 15% in capital gains taxes. The remaining $8,000 could then be taken from their Roth IRA, and no taxes would be due on those funds. In this example, the couple would be able to get the $60,000 they need, without having to take so much from any one account as to push them into a higher tax bracket.

As with most things financial (and often non-financial as well), diversification is the key. Ideally, when clients reach retirement, we would like them to have some money in qualified accounts (for the current deduction and tax-deferred growth), some money in non-qualified accounts (for potentially lower capital gains rates), and some money in tax-free accounts (for tax deferral and tax-free distributions).

If we knew today exactly what tax bracket each client would be in when he or she eventually retired, it would be easy to know what accounts to fund now. Since it is close to impossible to predict what tax bracket a client will be in many years down the line, or what changes may be made to the tax structure in the next 10, 20, or 30-plus years, the best advice is to have eggs in as many baskets as possible.

We coach our clients not to fear (or loathe) taxes. After all, paying taxes essentially means they have made money. However, changing the psychology is hard and can take time, so planning a strategy upfront to take advantage of whatever structure exists in the future is paramount. That way, when it comes time to start taking withdrawals and enjoying the fruits of their labor (or taking the family on that Alaskan cruise), we can help our clients control the tax situation in a much more efficient and less stressful manner.

Image via iStock.


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