Everyone hates paying taxes. It’s OK. Go ahead and admit it. You hate paying taxes, too.
Most of us have very little real control over when and how we pay taxes. We work for a company that pays us. They want to pay us on a regular basis and we want to get paid on a regular basis.
More important, they want us to add value and are willing to sweeten the salary deal should we add that value. Of course, that sweetened salary means more taxes.
And we all hate paying taxes. But we know we need those taxes to get the salary that puts food on our table, clothes on our back, and a roof over our head.
If only there was at least a way to manage our earnings so those tax bills didn't come all at once in any particular year.
Those of you with small businesses know there’s a way.
It doesn’t prevent taxes from being paid, but in can help even things out by having you avoid getting hit with an outlier tax bill in any one year.
Here’s a rather interesting thought when it comes to executing a retirement strategy: Once you retire, it’s like running your own business. You determine how much to spend and, when it comes to your own retirement accounts, you determine how much to pay yourself.
Your retirement income can come from several sources, some of which you have maximum control over, some of which you have modest control, and some of which you have absolutely no control over at all.
What’s more, not all that income is taxed at the same rate, even income coming from assets over which you have total control.
That’s why, when you leave your company sponsored retirement plan, determining whether to roll the assets over into a traditional pre-tax retirement plan or convert some portion of those assets into a Roth IRA can’t be taken lightly (see, “401k Rollovers: To Roth or Not to Roth – 7 Fiduciary Questions,” FiduciaryNews.com, August 8, 2017).
Retirement income you can’t control could include any pension payments you receive on a regular basis.
You have some control on the timing of Social Security payments, but you’ll eventually receive them just like any other pension payment. These payments may or may not trigger taxable events.
Then there are those payments you receive from your own accounts. Most of these will create tax liabilities, but one popular type of account won’t.
Traditional savings accounts (like brokerage and bank accounts) are considered taxable accounts. They produce three types of income: interest, dividends, and capital gains. When managing a taxable portfolio, you will often consider the tax consequences of the various assets within that portfolio. This allows you to control the tax impact in any given year.
For example, you might want to shun interest-bearing securities altogether because these produce income at the highest marginal rate. Likewise, you may decide to take capital losses before year-end to avoid paying taxes on the capital gains you amassed throughout the year.
None of this calculus means a hill of beans for your IRA account. All income – interest, dividends, and capital gains – is taxed at the same rate.
Unfortunately, this is the highest marginal rate. When you begin making withdrawals from your IRA, you’re taxed it all came from interest, even for income generated from sources normally subject to lower tax rates.
The situation becomes more acute when you reach an age where minimum distributions are required.
Then, the brilliant advantage of deferring taxes that made the traditional IRA so attractive all of a sudden becomes a devastating disadvantage.
You now suffer the onus of the Uncle Sam’s “pay me later” clause in that arrangement. And you know how much you hate paying taxes.
Thus was the customary way of looking at managing taxable and tax-deferred accounts during the retirement years. But this was before the advent of the Roth 401k and Roth IRA.
The Roth counters the traditional “pay me later” clause with a compelling “pay me now” offer. Pay the taxes on the money now, and save it tax free for the rest of your life.
Long-term, this can have a dramatic impact on one’s ability to live a comfortable retirement.
Remember, “comfort” isn’t defined purely by “wealth.” It really means “doing whatever I want, whenever I want, without anybody interfering with my right to do so.”
OK, this may sound a bit libertarian, but, philosophy aside, I’m pretty sure that, given the choice, living a retirement without the burden of taxation represents an ideal we’d all prefer.
While we can’t eliminate the tax beast, we can manage it. That’s the real advantage of the Roth retirement vehicle.
During retirement, we’ll need to tap our retirement savings plans to do what we want when we want to do it. These distributions can have an impact on the taxes we pay, which means the “cost of doing business” goes up.
When this happens in retirement, just like when it happens in business, we need to manage our resources in such a way as to mitigate tax-related costs.
Here’s a simple example to show you how it works. Let’s say you need $10,000 more this year to fund your retirement activities.
If you take it from your traditional IRA, the entire amount pushes you into a higher income bracket.
You can opt to take it from capital gains in your taxable account, but you feel there’s too much upside potential in the stocks you’d need to sell so you don’t want to sacrifice the portfolio’s future investment growth.
If you had a Roth IRA, you could take that $10,000 out free and clear and not have a worry about taxes.
We normally think of the Roth IRA option in pure tax terms. Truth be told, it’s a tax-sneutral decision unless you think your future tax rates will change (which means you have to predict which way the wind is blowing in Washington DC and your state capital when you retire and this is an awfully difficult prediction).
Looking instead at Roth IRAs as being a third type of account (in addition to taxable and tax-deferred savings account) that helps better manage post-retirement taxes may be a more vital view.
Indeed, this kind of “asset allocation” may have a more immediate impact on retirees than any other.