The Three Buckets of Money
As a financial planner, it is a rarity to see people properly tax diversified when saving for retirement. Most savers consider the tax deductibility of their investments, such as a 401(k) or IRA contribution, but never consider the tax impact on future income distributions.
I was recently working with a young dentist who was maximizing his 401(k) contributions in his company’s profit sharing plan. The young dentist was in a 25% income tax bracket with a net effective tax rate after deductions of less than 10%. I asked the young dentist why he did not create a Roth 401(k) option under his pension plan trust. He told me that his financial advisor never gave him the option. The financial advisor ignored the tax impact on future distributions for his client. Currently, the young dentist is most likely in the lowest tax bracket of his lifetime and the advisor allowed the young dentist to make pre-tax contributions to a tax deductible 401(k) plan. This is not tax wise! A tax savvy advisor would recommend the Roth 401(k) option for this young dentist (assuming that this option is viable under the plan).
As the dentist practice matures, his income tax bracket may grow from the 25% bracket to potentially the top tax bracket of 35%. Furthermore, tax rates may increase in the future as federal budget deficits swell. If this occurs, making an after tax contribution today with a future tax-free retirement income stream is the most tax efficient saving method. If it makes sense in the future to change strategies, having the flexibility to choose between the Roth 401(k) and the traditional 401(k) will make the transition easy for the investor if the 401(k) plan is designed properly. Finally, since the young dentist is a great saver for the future, he may be in the highest income tax bracket during retirement. Why would you save $0.25 on a dollar today to pay $0.35 on an inflated dollar at a future date? Considering future tax rates is imperative to maximizing your wealth and enhancing your future retirement income streams.
I want to introduce you to a retirement tax diversification strategy called the Three Buckets of Money. This strategy will enlighten you to the tax impact as you earn, grow and spend your money. The Three Buckets of Money will help you strategically save money with the future in mind regarding tax diversification, asset allocation and product diversification. I will be discussing strategies utilizing the Three Buckets of Money over the next several articles that I have used to save my clients significant amounts of taxes, enhance their lifestyles, make their dreams realities, and leave legacies to their families. Let’s examine the Pre-tax bucket of money and how it can help build financial security for your retirement.
The Pre-tax bucket of money as illustrated is the most common and popular method to save for retirement. You are contributing money in the bucket on a before tax basis, such as a 401(k) contribution. This means that the government is allowing you to use their tax money temporarily so you can build wealth for retirement. As the money grows in the bucket, it is tax deferred until a future date. There are no taxes on the growth until you withdraw the money. When you take distribution from the assets in the pre-tax bucket, you will pay taxes at your then current income tax rate. Distributions can be subject to a 10% tax penalty if withdrawn prior to age 59 1/2. Also, the federal government will allow you to tax defer the income tax until age 70 1/2. At that time, the government wants their tax money. If you do not take required minimum distributions from the qualified retirement plan, there is a 50% tax penalty in addition to the ordinary income taxes. Ouch! This means you are forced to take distributions or pay a huge price. At death, the assets in the pre-tax bucket are allowed to transfer to a spouse without incurring income taxes. However, if the beneficiary of the tax qualified plan is a non-spousal beneficiary, income taxes must be paid at the beneficiaries income tax rates. If the descendant has estate tax consequences, the qualified money could be double taxed at death (income taxes in respect to a descendant and estate taxes).
The types of qualified retirement plans that are inside the Pre- tax bucket are Individual Retirement Accounts (IRA’s), Simplified Employer Pension Plans (SEP’s), Simple IRA and 401(k) Plans, 401(k) plans, profit sharing plans, defined contribution plans, and defined benefit plans. The IRA plan is for individuals that do not have an employer sponsored retirement plan. You are allowed to contribute $5,000 per year in 2010. If you are age 50 and older, there is an additional $1,000 catch up provision. However, there are income phase out provisions if you are in an employer plan or your spouse is an active participant in an employer plan and you are not.
Defined contribution plans such as a Simplified Employer Pension Plan (SEP) are designed for self employed individuals with a small number of employees. You are allowed to contribute up to $49,000 per year, but the employer must contribute the same percentage to his employee’s accounts due to nondiscrimination rules. This can be a very expensive retirement plan for the employer if s/he has several employees.
The Simple Plans allow you to contribute up to $11,500 per year with a catch up provision of $2,500 if you are age 50 and older. Simple Plans limit the burden on employers with either a 3% dollar for dollar match or an employer 2% mandatory contribution. Also, the employer has the flexibility to discontinue its contribution in the event of a business hardship two out of five years. The great aspect of the Simple plans is that if an employee chooses not to participate, the employer is not required to make an employee contribution under the matching formula.
The 401(k) plan allows employees to contribute up to $16,500 per year with a catch up provision of $5,500 if the employee is age 50 or older. Often, there is a company match up to a percentage of salary.
The profit sharing plan is an employer sponsored plan based on the profitability of the corporation. It is at the discretion of the employer if there will be a contribution in any tax year. Furthermore, all contributions to the plan are made by the employer.
The defined benefit plan is the most lucrative employer sponsored retirement plan. The plan benefits are formula calculated based on longevity with the employer, employee’s age and income. This benefit pays out a monthly income for the life of the retired worker. Many state and federal government employees have a defined benefit plan for retirement.
The qualified retirement plans are the most popular types of retirement plans, but the most misunderstood when it comes to tax savings. To determine your savings rate into these types of plans, you must examine your tax rate today and project your tax rate when you take future income distributions. The qualified retirement plan is an awesome tax savings vehicle if built properly and an absolute tax trap if built improperly. If your employer provides a company matching contribution, you must take advantage of this retirement savings incentive because you are receiving free money. Let’s take a look at a well built qualified retirement plan.
John Smith works for ACME Inc. and earns $78,000 per year of income. John is age 55 , has a total of $55,000 in his 401(k) plan and contributes $10,000 per year. His wife is a homemaker and they have no other retirement savings. John’s marginal income tax rate is 25% on income above the $68,000 threshold due to filing jointly. Since John saves $10,000 per year for retirement, he is saving $2,500 in federal income taxes. At John’s retirement, he is projected to have social security income, small pension from a previous employer, Roth IRA and his 401(k) savings. His taxable income in retirement will fall into the 15% income tax rate. John will take distributions in a lower tax rate, therefore, saving himself thousands of tax dollars in future income taxes.
Let’s take a look at how saving too much in a pre-tax 401(k) plan may not be prudent tax planning in your distribution years. Suzie James works at ABC Inc., earning $130,000 per year as an advertising executive. She is 50 years old, has a defined benefit pension plan, 401(k) plan, deferred compensation plan, will have debt free rental property at retirement, and assets in her brokerage account. She is maximizing her 401(k) contributions to include the age 50 catch up provision. Due to her anticipated retirement lifestyle, she will need $175,000 of pre-tax income. During retirement, Suzie’s income tax rate will increase from the 25% income tax rate to the 28% marginal tax rate. In this situation, tax diversifying her investments could help her lower her tax bill during retirement. Contributing to a Roth 401(k) plan in a lower marginal income tax rate with the anticipation of a future higher income tax rate may save Suzie thousands of dollars in income taxes during retirement.
Carl works at Smith Inc. and earns $60,000 per year of income. He is 45 years old and contributes $5,000 per year on a pre-tax basis in his 401(k) plan. His wife is a homemaker working hard to raise their 2 children. He has a $15,000 401(k) balance, $33,000 in a rolled over IRA from a previous employer and $5,000 in a savings account. Carl is currently in the 15% income tax bracket. He is trying to make the decision to either contribute to a pre-tax 401(k) plan to take advantage of the tax deduction today ,or make an after tax Roth contribution to take advantage of tax free retirement income streams. Due to Carl limited financial resources, he must make every dollar count to prepare for his family’s future. Which option should he choose? The answer is that it doesn’t matter which option he chooses. If he is in the same tax rate during the contribution stage as the income distribution stage, then he is tax neutral. He will have the same amount of money net after taxes either way. The only concern that he must address is the potential for higher marginal income tax brackets due to federal and state government budget deficits. If governments increase tax brackets by only 1% in the future, he will have greater tax efficiency with a Roth 401(k) plan.
As you see, paying keen attention to future income tax consequences on passive future income streams is very important in managing your future income taxes. Your retirement contribution decisions today can have a big financial impact on your future net after tax income and net worth. Therefore, seek guidance from a financial professional who has experience in mapping out potential income tax rates for future retirement distributions. The financial professional will be worth its weight in gold while helping guide you through the maze of future retirement income distributions.
Jeffery Palmer offers investment advisory services as a representative of Prudential Financial Planning Services, a division of Pruco Securities, LLC (Pruco), and securities products and services as a Registered Representative of Pruco. 1-800-621-6690. The Palmer Group is not affiliated with Pruco. Other products and services may be offered by a non-Pruco entity.