BY AL SEYMOUR, CHFC®, CLU®, CRPC®, CASL®, AEP®, CAP®
In the investment world, the term “Three-Legged Stool” is often used when referring to three components of retirement income: pensions, Social Security and personal savings. What I found is that the term is often used in many different industries to get across a variety of important concepts or relationships. One that we will focus on today is the “Tax-Efficient” Three-Legged Stool.
The “Tax-Efficient” strategy incorporates having retirement assets invested in taxable, tax-deferred and tax-free investments.
- Taxable investments (or after tax) are outside of annuities, IRAs, 401ks, 403bs and other qualified vehicles, and are taxed potentially at lower rates.
- Tax-deferred assets are IRAs, qualified plans and annuities. This money gets tax-deferred treatment until withdrawn for income. When withdrawn it’s taxed at personal income tax rates.
- Tax-free are Roth IRAs, Roth 401ks, and municipal bonds. If IRS rules are followed appropriately, they will indeed provide tax-free income.
We often hear that “two things in life are certain: death and taxes.” Many in retirement find it frustrating that after years of saving and growing money in their IRA, when they spend it, they are taxed more than they anticipated. Investors quickly forget that these dollars were invested on a pre-tax basis and allowed to grow tax-deferred. No taxes have been paid on the money. My clients have heard me compare the IRS to the old “Fram” oil filter commercial phrase, “You can pay me now, or pay me later.” Quite frankly many of us would rather not pay them at all, but that would not be wise.
The problem for savers is that if you have too much of your retirement saved in pre-tax IRAs and 401ks, you will pay tax on every dollar you take out in retirement. Having more than one “leg” to your stool can help you manage taxes better. If you have Roth money or after-tax money saved, you can access that money without creating a 1099 for the withdrawal. If you have an emergency, do you want to have to pay taxes on the money you need to take out? If tax rates are high, would it not make more sense to withdraw from a tax-free account? Conversely, when tax rates are low, take more from IRAs and 401ks because you will net more on an after-tax basis during low tax rate periods.
You can see why a discussion of how your investments are allocated based on your risk tolerance and goals is important, but don’t forget about taxation of those same investments before and after retirement. It is wise to work with both your tax advisor and financial professional. The amounts needed in each leg of the stool will be different for each individual. Careful planning could help you find the right balance and ultimately keep more money in your pocket.