With the end of the year approaching, many of my clients have become increasingly tax conscious, and with good reason. We’ve had the largest major overhaul of the tax code in decades, changes in deductions, deductibility, marginal rates, standard exemptions, credits, and even estate taxes. Many people who were familiar with the tax “logic” and structure of the past have had to re-learn the system, even CPAs and attorneys who provide tax advice on a regular basis.
But, when the rubber meets the road, most tax advice I see and read is laser focused on simply avoiding current year tax. Well-meaning, but completely incorrect professionals call this work “tax-savings.” Unfortunately, the objective of avoiding current year tax can, and often does, come with incredible tax cost down the road for one primary reason: the #1 recommendation given by tax professionals to minimize current year tax is to maximize retirement plan contributions. This strategy typically does not save tax at all. It defers tax. In fact, over the long term, exclusive use of qualified plans as a wealth accumulation vehicle is likely to trigger more effective taxes in the future than a client can possibly defer in the current year, assuming rates and laws don’t change.
Types of Accounts
There are only three types of accounts, from a tax standpoint, that a person can use to store and accumulate wealth. 1) Tax-Free, 2) Taxable, 3) Tax-Deferred. Each is a creature of the tax code, and their pros and cons are largely knowable.
Since death and taxes are the only guarantees in life, tax-free money probably sounds too good to be true. But it isn’t just a unicorn! Roth accounts and properly designed permanent life insurance vehicles can allow for accumulation of wealth on a tax-deferred basis, and distribution on a tax-free basis, as long as the proper IRS rules are followed. Contributions are made on an after-tax basis, so there is no current year deduction.
The primary advantage of tax-free money is that it is tax-free! The primary disadvantage is that it stops being tax-free if you break rules in the tax code. Roth account distributions become taxable if they aren’t 5 years old before distributions are made, and penalties are assessed for distributions of earnings prior to Age 591/2. Roth accounts also allow for rather low contribution limits: a married couple, filing jointly, is not allowed to make Roth IRA contributions when their modified adjusted gross income exceeds $199,000, and phase outs for contributions begin at MAGI of $189,000.
No such limits or age restrictions exist for permanent life insurance products. It is, however, possible to “overfund” a life insurance policy to the point that it becomes a Modified Endowment Contract, which would make cash values taxable upon distribution. Even in this scenario, death benefits would still be paid income tax-free.
Taxable accounts are better known by their product names: Savings Accounts, CDs, Brokerage Accounts, Non-Qualified Advisory Accounts, etc. Contributions to these accounts are also made on an after-tax basis, so savers don’t receive a current year deduction.
There are two primary benefits to these accounts. First, sale of an asset held at least 366 days will trigger capital gain taxes instead of ordinary income taxes. That can be a difference of up to 20% (35% ordinary vs 15% capital gains), with a maximum capital gain rate of 20%. That tax savings is real, and permanent (unlike the deferral we’ll discuss momentarily). It is also possible to use unique tax avoidance strategies in taxable accounts by using some trust strategies for portfolios exceeding $3,000,000 and incorporating bonds that can be triple tax-free.
The primary downside of taxable accounts is that capital gains, interest, and dividends earned in any given year will trigger a tax bill. Over time, that tax bite can wipe out a significant portion of an investor’s portfolio.
Tax-deferred accounts are usually known by their IRS code section names: 401(k), 403(b), 457 plan, Traditional IRA, etc. Conributions are almost always tax-deductible, maximum contribution limits exist, penalties occur for most withdrawals prior to age 591/2, and, upon distribution, every dollar will be taxed at the participant’s ordinary income tax rate (up to 37% federally in 2018). At age 701/2, the IRS mandates a required minimum distribution (RMD) based on age and account balance.
The primary advantages, from a tax perspective, are that contributions provide a current year income tax deduction and that growth in the accounts is tax deferred. However, tax deferral is not tax savings if withdrawals occur at the same or higher tax rates. It is deferral. Remember that taxes will be due upon distribution upon all contributions and all growth.
The Tax Shadow
So, how can exclusive use of qualified plans as a wealth accumulation vehicle trigger more effective taxes in the future than a client can possibly defer in the current year? Very simply, income needs don’t often go down significantly in retirement. A couple that needs $10,000 per month while working is probably going to need or want $10,000 per month when they retire. If all or most of their wealth is in tax-deferred accounts, ordinary income tax would apply to each dollar of distribution.
Furthermore, social security income is taxed on a progressive system. Individuals with less taxable income have tax assed on a lower percentage of their social security payments. For individuals with higher income needs, the distributions often maximize the taxable portion of social security payments.
Alternatively, people who store wealth across multiple types of accounts (from a tax perspective) give themselves flexibility when they take distributions. Distributions from tax-free accounts aren’t taxed at all, while distributions from taxable accounts are usually only partially taxed and are taxed at lower rates. In fact, the combination of accounts can be so effective that my clients who use them often have far higher after-tax income per dollar of net worth than people who only used tax-deferred accounts.
So, the next time you hear a CPA or financial advisor say “just max out your 401(k) to save taxes,” I want you to do two things. First tell them it isn’t tax savings; it is tax deferral. Second, call us to help you create a real, long-term tax-efficient strategy.
Just after college, Austin experienced profound loss with the early and unexpected death of his father. The positive impact of financial planning for his family eventually led him to pursue a career in financial service, and he joined Wealth Advisory Group in 2013. Austin received his bachelor’s degree from the University of Evansville, summa cum laude and has obtained the Retirement Income Certified Professional® designation from The American College. He is a member of the BEI Network of Exit Planning Professionals™ and is a Certified Exit Planner™.
Austin’s practice specializes in risk mitigation and wealth planning for business owners and medical professionals. His team provides expert wealth management, personal planning, and business transition planning for physicians, executives, and entrepreneurs.
Austin Bransgrove is a Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. Park Avenue Securities LLC (PAS) is an indirect, wholly-owned subsidiary of The Guardian Life Insurance Company of America (Guardian). PAS is a registered broker-dealer offering investment products, as well as a registered investment adviser offering financial planning and investment advisory services. PAS is a member of FINRA and SIPC. Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Please consult your tax, legal, or accounting professional regarding your individual circumstances. Wealth Advisory Group LLC is not a registered investment advisor. Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. CA License #0L00236