I have no clue! That’s how much I know about the future of tax rates. Just like I don’t know about the future of the capital markets or what your stock returns will be over the next 10, 20, or 30 years. So, what do you do? In my opinion, you should diversify the taxability of your savings accounts just the same as you diversify the investments within those accounts.
Different account types act as “wrappers” around your savings, and each wrapper has its own rules. For purposes of this blog, I am only talking about the tax rules to each. I will assume that you follow all the other rules, like only distributing from retirement accounts after 59.5 years old, or only taking distributions from a Health Savings Account for qualified medical expenses. Also, none of my talk below involves insurance products or accounts. Those accounts may have different taxability from what I describe below.
There are three general categories for these accounts, which can be broken down below:
Also sometimes called nonqualified accounts, there are no wrappers around this type of account. I wrote a whole blog on the benefits of these accounts called Investing Outside of Retirement Accounts.
Any money you put into these accounts does not reduce your taxes (you do not get a deduction for a contribution). When you put money into these accounts, you create “basis” - basis is a fancy term for “I already paid taxes on this money”.
When your balance grows in these accounts due to investment returns, that growth is taxable when it is “realized”, or sold. Any time an investment pays cash, you can be sure that you will be paying taxes on that income. Once you pay taxes on that money, it gets added to your basis.
Your basis can ALWAYS be accessed, tax free, in these accounts. That money is yours, and there are no penalties to access it again when it is in a taxable account. Keep in mind, that you may have to sell an investment to get access to the cash, which may then trigger taxes on any investment gains, but the basis always comes out tax free.
With this type of account, you need to be wary of the impact of any investment sales to ensure you will be able to pay the taxes that will be due. Your taxes will depend on the type of investment and how long you have been holding the investment before you sell it.
Tax Deferred Accounts
There are a few different types of tax deferred accounts, but some common accounts are retirement accounts like a traditional IRA or a pre-tax 401(k).
In these accounts, you are making the decision to not pay taxes on that income today, and to pay taxes on these funds in the future.
If you think about “basis” again, since you never paid taxes on the money that goes into these accounts (usually), you do not have any basis in the account. It is $0, which means any money that you take out of here in the future is considered taxable income!
Any savings that you have in these accounts upon entering retirement should be assumed that a piece of the whole savings account will be owed for taxes. Make sure you do not assume that the amount you distribute from the account will be the same amount that you’ll be able to spend.
Tax Free Accounts
Finally, we come to “tax free” accounts, which means you will not pay taxes on this money again (assuming all rules are followed). Some common accounts are Roth retirement accounts (like a Roth IRA or Roth 401(k)) and Health Savings Accounts.
Once money goes inside of these accounts, any investment gains or distributions in the future are non-taxable. Another way to think about this is that the entire account is “basis”, even the investment growth which is sheltered from taxes.
If you saved all of your money in these accounts, you would not pay taxes on a distribution from these accounts. But is that a good thing? You may have pre-paid taxes on ALL of your savings throughout your entire career, which resulted in a smaller savings pool to live off of during retirement.
In theory, never paying taxes again sounds great! But in practice, this likely would not result in an optimal outcome when compared to finding a balance with the other account types. My reasoning can be explained below in how taxes work.
The Progressive Tax System
So, where does that leave us with how individuals should be saving? The typical argument is “I am probably in a lower tax rate now than I will be in retirement”. But this argument seems to forget that we live in a progressive tax system. A progressive system means that your first dollar of income is typically taxed at a lower rate than your last dollar of income.
Having flexibility in the different accounts allows you to pull money from tax-deferred accounts to fill up the lower tax brackets, and then distribute from tax free accounts (or the basis of your taxable accounts) for the rest of the needed money.
As an example, if you made a salary of $75k today as a single individual, your marginal tax rate is 22%. If you saved $5k into a tax deferred account, you would save $1,100 in Federal taxes ($5,000 * .22%). Consider you do this every year for another few years with the same outcome.
Now in retirement, you need $50,000 in a specific year. As a single individual, you are taxed at 10% up to $9,875 of income, and the standard deduction is $12,400 which creates 0% tax. In other words, if you distribute $22,275 from your tax deferred accounts, this would result in $987.50 of taxes (first $12,400 tax free and then 10% tax on the next $9,875). To make up the rest of the money needed, you could distribute from your Roth account or taxable account.
In my example, you saved $4,900 in taxes from deferring that income at the 22% tax bracket ($22,275 * 22%) to pay a total of $987.50 of taxes on that money in retirement. That is $3,913 of tax savings from being smart in your distribution strategy and having the different accounts to pull from.
This is an oversimplified example for illustrative purposes, but gives you an idea of how you can choose where to distribute money from during retirement. If you have tax-diversified sources of money, you create the flexibility to be more strategic with your tax avoidance.
And finally, it may seem as though I am advocating for contributing to tax deferred accounts while you are working, but that is not the case as you would not be able to have this flexibility without contributing to tax free accounts. I am simply saying you should find a balance between the two of them. In my example, when you retire the lowest tax bracket could be 30% for all I know. I am not willing to take a bet either way.
Flexibility is Key
As I often say, having flexibility is key, and being able to pivot as your life and laws change is a true form of financial freedom.
When you have a diversified approach to the different savings accounts, it gives you an opportunity to effectively distribute your funds.
Making a bet that tax rates MUST increase, and therefore you will put everything into a Roth account today is bad planning in my opinion. Nobody knows what the future of tax rates will be, nobody knows your financial situation when you retire, and nobody knows exactly what you are going to do once you retire.
As I mentioned, my example is oversimplified, and there are some more complex factors to consider when you get to retirement like Social Security income, Medicare premiums (which can change based on income), and the fact that tax deferred savings accounts typically have Required Minimum Distributions, which forces you to take taxable distributions when you hit a certain age.
But I hope this gives you the idea that designing a portfolio to be tax-diversified can have some added benefits and create flexibility for you when it comes time to start enjoying the fruits of your labor.