Having a basic understanding of taxes can save you tens, if not hundreds of thousands of dollars over the course of your life. The type of accounts you have maybe just as important, if not more important, than the investments in them.
There are three ways to be taxed; now, later, and never. For the remainder of this article, taxed now, later, and never are in reference to the taxability upon distribution from your accounts.
These accounts are taxed every year. Your checking account, savings account, or brokerage account are the most common. Access and liquidity are the most common reasons people hold money in these account types.
Your Traditional 401k, Traditional IRA, and SEP IRA are some of the account types that fall into this bucket. Most people will use these accounts for two reasons as a means to save for retirement. The first, to lower their income tax in the current year. Second, they believe they will be in a lower tax bracket upon distributions than they are today.
Your Roth 401k, Roth IRA, and life insurance are a few examples of taxed never accounts. Again, people will use these accounts for two reasons as a means to save for retirement. First, they believe their tax rate will be higher in the future than it is today. Second, they are willing to pay taxes on their money today for tax-free income in the future.
Historic Tax Rate
50 years ago, an individual making $100,000 had a marginal tax rate of 70%. In 2020, it’s 24%. The chart below shows marginal tax rates for individuals and couples making $100,000 over that last 50 years and their corresponding tax rates.
After looking at the chart, is it unrealistic to think rates could move dramatically higher over the next 50 years? Being a betting man, my money is on higher in the future. Being that we don’t know which direction they will go, why not create a strategy where you control what you pay in taxes? That’s where the tax diversification triangle comes into play.
The Tax Triangle
Before going any further, I need to address the tax nerds reading this. First, I say tax nerds lovingly, as I happen to be one. Second, I take some liberties in oversimplifying complex tax concepts. All I ask is for you to take what I’m saying at face value. There, I said it, let’s move on!
This first image depicts what I see most commonly from a tax diversification standpoint. Roughly 20% of someone’s money in taxed now accounts and 80% in taxed later accounts. Although it is becoming more common to see investors with taxed never money, the tax-free bucket has been left untouched for some. Not surprising since Roth IRAs were only established in 1997.
The top line of the image below shows the money invested in each account before it is taxed. The second line of the image shows the net money received after taxes are paid. In this example, we assume a 25% tax for federal and 5% for state.
Let’s look at another example. In example two, we’ll look at the diversification of accounts. Instead of 20% being in the tax now bucket and 80% in the taxed later bucket, we’ll explore a different approach. This time we’ll look at 30% in tax now, 40% in taxed later, and 30% in taxed never.
The top line of the image shows money invested in each account before it is taxed, pre-tax. The second line of the image shows the net money received after taxes are paid. In this example, we assume a 25% tax for federal and 5% for state.
By reallocating the money your accounts are in, you save yourself around $240,000 in taxes. It’s an additional $240,000 without talking about investment performance or additional contributions. A simple concept of taking money from one pocket and moving it to the other.
Controlling Your Own Tax Bracket
My Assumption is Wrong
Let’s say that my assumptions are wrong, and tax brackets are lower when you retire than they are today. You can still determine the most efficient way to take the money out. Maybe you are in a 14% tax bracket and long-term capital gains (LTCG) are still at 15% for you. Take the money from your taxed later bucket. Once depleted, you can move to your taxed now bucket and then to your taxed never bucket.
My Assumption is Right
I’m not predicting, but let’s say your tax bracket in retirement is now 35% federally and LTCG rates are still 15%. You have the ability to defer taking money from the taxed later bucket in favor of paying 15% on your taxed now bucket. Maybe you are looking to buy a second home or rental property in retirement. Instead of having 80% of your money in the taxed later bucket and having to pay an arm and leg in taxes to make the purchase, you have two buckets to choose from, taxed now and taxed never.
I’m Half Right
The average retiree is looking at a 25-35-year retirement. In the 25 years from 1970 to 1995, tax rates moved dramatically. This strategy allows you to take from the account that is most efficient based on the tax bracket you fall into. In year 5 of retirement, it may make sense to take from taxed later. If the tax code changes in year 6, no problem. Stop distributions from the taxed later bucket and start drawing from the taxed now or never accounts. Think of it as a three-headed faucet. You have the ability to turn on and off the distributions based on whatever favors you the most in a given year.
These examples oversimplify a complex tax code. Without knowing how the tax code will change in the years and decades to come, I favor a plan with flexibility. By diversifying where you put your money you gain flexibility. You also have control over how and when you’re taxed. The net result may be more money for you or your heirs simply by understanding how you’re taxed.