HENRYs: Are you utilizing your most powerful Tax Weapon?
We can't control a lot right now. Our day to day lives. Our work. Maybe even our health...it's all scary to think about. And as we all know, we definitely can't control what's going on in the stock market. So lets make sure that we're controlling the areas of our life and our finances that we can. Here's one: Make it your mission to understand the tax opportunities ahead of you and the tax discounts staring us all in the face right now. Be proactive. Don't let this financial low point go to waste! - GD
Nobody likes paying taxes. I think we’re all on the same page there. But are you doing everything possible to limit your tax bill?
Those of you that already drank your morning coffee were right to follow up my simplistic question. The better question is actually,
“Are you trying to limit the taxes you’ll pay TODAY or LATER?”
For young people (particularly those with high incomes and an accumulating net worth) this is one of the most important decisions that you can make each year.
All our retirement accounts basically fit into one of two buckets for tax purposes…
After-Tax (Roth) dollars.
(We’ll discuss stock options, restricted stock etc. deferred comp etc. on another post).
Well, which bucket should we be storing our money into for the future?
Let’s start by talking about traditional IRA’s and 401(k)’s. This is money that you’re saving for retirement BEFORE you ever had a chance to pay taxes on it. For example, if you contributed $19,000 to your 401(k) in 2019 and your income was $200,000, then you were only taxed on $181,000 of your total income this year: that $19,000 was intentionally excluded from your taxable income…Cool!!
But it’s the back end of the equation in which the federal government comes roaring back into your life demanding it’s cut. Every single dollar that you take out of your traditional 401(k) or IRA later in life is taxable at ordinary income rates. I’d read that sentence again…because for way too many people approaching retirement, that fact becomes the ticking time bomb of your retirement plans!
It’s helpful to think of this pre-tax money as money that’s held in partnership between you and the federal government.
The government agrees not to make you pay taxes on the money as it’s being contributed in return for their share of the entire account balance later in life. That money is never totally yours until you give the government it’s piece…until then you have a big, old, liability sitting right smack dab in the middle of your IRA & 401(k).
Let’s use a real-life example. When a retiree comes into our office and shares with us the exciting news that he has $2 million in his IRA, it’s our job to make sure that he’s aware of one unfortunate fact. Because that $2 million has never been taxed (it’s in a Pre-Tax IRA), if that client were to take all of the money out of the account (to buy a vacation home or whatever), he would have to pay taxes on the full $2 million at his ordinary income rate. This means that he owes $600,000 to 800,000 to the federal government before he can collect the rest and, as a result, that gigantic $2 million IRA will turn out to be little more than half that when it’s all said and done. So, not only is the government getting its percentage of the money that he contributed along the way (which, to be fair, has never been taxed), it’s also taking a significant chunk of the investment growth that he’s earned over the past 30 years.
A common (& fair) question at this point might be “Well wouldn’t his income be lower later in life because he’s no longer working?” Maybe! Though we typically underrate how much income we’ll need in retirement, so the difference is not as great as we imagine. (We still need to live right?) We may also have real estate income, investment income, business income etc. The greater point, however, is to focus on the fact that you’re being taxed on a much larger account balance by waiting. Instead of being taxed just on the contributions each year along the way…you’re allowing yourself to be taxed on your contributions AND 20/30 + years of compounding growth at the end.
Not only that, but pre-tax retirement accounts leave you at the mercy of changing tax laws! If taxes increase in the future, well, then the federal government will own an even larger share of your pre-tax 401(k) or IRA. Most tax and financial professionals believe that taxes are only going to go up over time; our current tax rates are at their lowest ever…Do you really want even the possibility that higher tax rates may eat up more of your retirement dollars down the road?
Ok, so, the alternative: What’s the deal with Roth IRA/Roth 401(k)’s?
They work differently….You don’t get a deduction in the year that you contribute the money, but once the money is in your account, every dollar, including the growth, is yours (provided you follow the rules). Put another way, that $2mm that’s built up in your Roth 401(k) would be safe from ANY income taxes when you’re ready to take the money out. Well if have another 20-30 years for our money to compound, don’t we want as much of our money in the bucket that doesn’t require you to pay Uncle Sam on the growth?
Maximizing the money in our Roth bucket really comes down to two separate questions.
1. Are you contributing to a Roth IRA/401(k) or a Traditional IRA/401(k)? And If you’re a high earner and can’t contribute to a Roth IRA directly are you availing yourself of the Backdoor Roth option?
2. Are you being proactive about moving money from the Pre-Tax bucket INTO your Roth bucket over time? It’s called a Roth Conversion & it’s a strategy in which you convert pre-tax dollars into Roth dollars by paying the taxes today that you put off in the past. Maybe you have $200g in your Pre-Tax IRA, and we decide to move $50g of that into a Roth IRA…After you’ve paid the income taxes on that $50g, that money moves into your Roth account and will get treated as a Roth forever.
I want to be clear that this is not always the right move!!! How such a strategy would impact your income tax bracket and whether you have enough cash liquidity to initiate this move may prove to make this strategy more trouble than it’s worth for you right now. (Personally, I max out my Roth 401(k) each year and I contribute the max ($6g) into my backdoor Roth IRA as well).
As always, my point is merely that we want to be aware of such opportunities and to educate ourselves to make the most empowered tax planning decisions that we can.
The next few years are especially important…Taxes are on sale right now. Being proactive about tax planning is a huge opportunity that we don’t want to go to waste!
If you are a HENRY wanting to stay on track and make sure you are utilizing your most powerful tax weapon, download our free checklist: