The tax control triangle

By Katherine Vessenes

Vestment Advisors

It is our belief that the tax consequences of your client’s investments will have a much greater impact on their future than even investment returns.

When I first started financial planning, we all had one basic assumption — push taxes into the future. The general thought was that our clients would be in a lower tax bracket for taking distributions from their retirement plans. About 12 years ago, I had an “aha” moment. What if that assumption was false?

If it were untrue, then we had done our clients a great disservice. Instead of paying their taxes now, when the rates are historically low, we would have pushed them into the future, when they are likely to be higher — a lot higher.

In fact, in order for a client’s tax rate to be lower in retirement, two things must happen:

1. They have to be taking less income. Out of all of our clients, I have only had three who said they would be happy living on a lot less money in retirement. Most people want exactly the same lifestyle in retirement that they are living now.

2. The other alternative is Congress will reduce the tax rates. The recent elections have shown that this is highly unlikely for the foreseeable future.

Given these options, I believe it is doubtful your clients will be in a lower tax bracket in retirement. Here is where the tax control triangle can give you a framework to discuss these concepts with your clients.
There are only three ways your clients’ income can be taxed:

1. Taxed now in non-qualified accounts. Or, as Ed Slott says, this is really a tax forever account because the earnings are subject to tax every year. Some assets that would fit in this bucket include:
  • Savings accounts
  • Mutual funds and investments held in the clients name
  • Income from real estate
  • CDs and money market accounts
2. Taxed later in a tax-deferred account. Here are a few of the type of accounts that allow for a tax reduction this year and to defer taxes until retirement:
  • 401(k)
  • 403(b)
  • 457
  • IRA
  • SEP
3. Tax free. There are only a few ways to get tax-free income:
  • 529 plans if used for college costs within the U.S.
  • Muni bonds
  • Roth IRAs
  • Certain kinds of investment grade life insurance
We tell our clients there are pros/cons with each of these buckets:

1. For the non-qualified accounts:
    a. Pros:
      i. The funds are liquid and available on a few days notice.

      ii. There are no penalties for withdrawing the funds.

      iii. It is very important to have emergency funds in this bucket.
    b. Cons:
      i. With these accounts being taxed forever, the tax burden really reduces the rates of returns.
2. For the qualified/tax deferred accounts:
    a. Pros:
      i. Clients can reduce their income for this year and their taxes by the amount that is contributed. So, a client who maximizes his 403(b) could invest $17,500 and not have to pay any taxes on that money. For those in the highest tax brackets, it might save them as much as $7,000 or more in taxes this year — money in their pocket.
    b. Cons:
      i. Unfortunately, there will come a time in the future where the client will have to pay the piper — the taxman. In retirement, all the funds in this bucket will be taxed as ordinary income.

      ii. Clients with a lot of money here face two big unknowns: They don’t know how much their funds will grow between now and retirement, and they don’t know what the tax rates will be.

      iii. There are also steep penalties for pulling the money out of the accounts before age 59 1/2.
3. The tax free/tax advantaged accounts

First, a little background. For retirement purposes, there are only three choices: Munis, Roths or certain types of life insurance. We don’t usually recommend munis to our clients due to poor returns and, in some states, the real risk of defaults. That leaves Roths and life insurance. For clients whose joint income is over $180,000, Roths are not usually an option. That means for many clients, the only way they can get tax-free income in retirement is through cash value life insurance.
    a. Pros:
      i. For either Roths or investment grade life insurance, the client invests the funds in after tax. The accounts grow tax free and can be withdrawn free of tax if done correctly. For Roths, this would be a direct withdrawal after age 59 1/2. For life insurance, it is usually done in the form of a loan.

      ii. Certain types of life insurance have some guarantees that are appealing to clients.
    b. Cons:
      i. For Roths, there are steep penalties for withdrawing the funds prior to age 59 1/2 (except for the basis).

      ii. Depending on the type of life insurance used, there may be surrender charges if the client decides to surrender the policy early. These charges would reduce the amount of funds the client could access.
It is important to have some money in each bucket, because that gives you more flexibility in retirement. If tax rates are high when you retire, then you can take the money out of the tax-free bucket. If they are low, you will want to take them out of the tax-deferred bucket. This way, you have options. Unfortunately, those folks who just blindly invested all their money in the tax-deferred bucket could wake up to some very unpleasant tax bills in retirement.

Our strategy:

1. First, we fund the non-qualified bucket to a level that the client feels comfortable with for emergency funds or liquid savings.

2. Next, we look at their tax-deferred options. For most clients, we recommend they invest at least to the point of matching. For some high-income earners, we recommend they max out their contributions, always explaining the consequences in retirement.

3. Finally, we look at the tax-free bucket and use Roths, if available, or investment grade life insurance. Sometimes, we use a combination of both.

4. Ongoing savings are used to fund the non-qualified bucket and the tax-free bucket in a ratio that the client feels happy about.

It is our belief that the tax consequences of your client’s investments will have a much greater impact on their future than even investment returns.