29 February 2008
Sometimes I am asked what changes I would make for people if I could have met them years before they retire. I do not want to use the words, “fixing mistakes,” because it is never a mistake to retire with money saved. I will say, however, that the one change I would make to most people’s portfolio is to urge them to think about the tax ramifications of investing much earlier than they do now.
Some of our clients have seen the flow chart we use to make decisions around pulling money out of individual retirement accounts (IRA) prior to age 70 ½ (but after age 59 ½), and usually in years when they do not even need the income. The reason we show this chart is to point out that often you can get money out of an IRA (or 401(k) for that matter) at your current – usually lower – tax bracket as opposed to waiting until 70 ½ when the IRS mandates how much you pull out each year based on your life expectancy. At that point, it is often too late to control which tax bracket you fall into. But the real issue here is that we all should be thinking about this for the 20 years leading up to retirement.
The hardest thing to do when you have children is to save for retirement. We parents sometimes will bankrupt our own retirement just to pay for our children’s activities and eventually, college. But it is while our children are in school that we should be putting money away for retirement and not just in 401(k) plans for the reason I mentioned above. Setting money aside in Roth IRAs, taxable accounts using low-cost and low-turnover mutual funds or even in building your own business that you will sell someday are all good ways to build assets that will eventually be in a lower-taxed position than IRA/401(k) money. IRAs and 401(k)’s are great accumulation tools but difficult distribution tools.
Building different buckets of assets takes very little effort. Of course we all should use the 401(k) at work up to any match possible (note to business owners – set one up for 2008 if you have not already), and sometimes more than that if we have strong cash flow. Above that, if you qualify to open a Roth IRA/Roth 401(k), do so. If you can just save $100 per month into an index fund, do so. The more automatic you make these things the easier it will be. The key is to do something in addition to the 401(k)/IRA so you have assorted buckets of money down the road that are in less-taxable positions.
And what if you are over age 50? First, use the catch-up provision on your 401(k) to do the extra $5,000 but consider putting it into the Roth 401(k) feature – doing just this for five to ten years will help you build some non-taxable investments to use for the extra spending in retirement. In addition, putting the catch-up contribution into the Roth side will not hurt much since you never could do it before and were used to paying the taxes on this $5,000 anyway. Also, since you are getting closer to retirement, consider stashing as much away as possible into a brokerage account that can be invested in some equities, but possibly more in bonds and cash to provide for the first five years of retirement income so that you do not need to worry about how your equities are performing in the IRA/401(k).
Many people save for retirement but do not plan for the distribution phase, creating tax complications in retirement. Thinking about tax control now will cause you to shift how you save money and you will be better off than your neighbors for it.