The 2019 IRS Limits for Retirement Accounts were recently released and savers will be able to put away more than ever into various tax deferred accounts.
With that comes one of the occasional and sometimes political debates of what will happen to our retirement accounts in the future? Potential negative risks in the future include means testing for deferral benefits, a cap on total account size, and a potential reduction of social security benefits based on retirement savings accounts.
We also can’t predict what tax rates will be in the future. In my short twenty years of earning income I’ve watched two tax reductions and one tax increase, all while the US government continued to run deficits. Its been 26 years since Ross Perot received nearly 19% of the vote running on a platform against deficits. (Political Alert!) Since then, both parties have blamed each other, one pointing to spending and one pointing to tax cuts. Total tax receipts have risen every year since 2009 and the country can’t figure out how to keep spending in line with its ever growing revenue.
Why does this mind numbing issue matter to an early retiree? You need tax diversity in your plan.
The Tools (Accounts)
The Pre-Tax In, Pay Taxes Coming Out Accounts:
The 401k, Traditional IRA, Self Employed IRA, Solo 401k, 403b, 457, and the Non Qualified Deferred Compensation Plan.
The After-Tax In, No Taxes Coming Out:
The Roth IRA
The Pre-Tax In, Potentially No Taxes Coming Out:
The Health Savings Account
After-Tax In, Lower Rates Coming Out:
The Regular Brokerage Account, Real Estate Investments.
The higher the benefits are with these accounts, generally the more restrictions that come with the account. The regular brokerage account provides the most flexibility, but requires funding with after-tax dollars and you pay taxes when you realize income. The HSA carries the most tax benefit (especially since its deferral can be before medicare and social security taxes), but contains the most restrictions on the use of funds and carries a 20% penalty.
How do you decide which accounts to use and when to use them? There is a ton of information already published recommending the investment order and I’ve found this thread on the MMM forums to be loaded with great information.
In general, the recommendation will go something along these lines:
- Utilize the 401k or similar employer provided plan first if your employer offers one. Use this at least up to the amount an employer match. This match is essentially part of your compensation that you’re gifting back to the employer when you forego utilizing your 401k
- Fully fund a Health Savings Account if you’re in a qualifying plan. This carries tax free benefit including social security/medicare taxes and the money can be used tax free for medical expenses.
- Fund the Roth IRA up to the maximum limit. The Roth IRA is the only account that carries the promise of no taxes on distributions. The Roth IRA also carries some income limitations and you may be fortunate enough to out earn your ability to contribute (yes, there’s a backdoor Roth for some people, but that’s beyond the scope of this). Even if this was changed in the future, the taxes would likely be no greater than the capital gains/dividend rates that you would have paid if you saved in a regular brokerage account. Contributions can also be withdrawn after five years and sooner in situations that qualify as an emergency.
- Some combination of contributing up to the maximum allowed in your employer sponsored plan plus a regular brokerage account.
So how does tax diversity come into play?
The first three steps in the investment order will take care of most investors 10-15% savings rate. Those who want to retire before the age of 59.5 have to start putting more thought into both tax diversity and liquidity. The limits on retirement accounts keep going up and that allows you to lock up even more money pretax. That may or may not be the best idea
Some questions to ask:
- How many years worth of living expenses do you need readily accessible for you retire?
- What is your tax rate today putting money in?
- What do you think your tax rate is going to be coming out?
- Will your state tax situation change?
If you want to look at some of these questions being answered for me, Big ERN used my situation as a case study. The recommendations were outstanding! ERN effectively pointed out that my split between tax sheltered assets and non-tax sheltered assets was only 20% regular / 80% in tax sheltered. I had some concern about this and one of my drivers to work an additional nine months was to improve this ratio. Assuming no change to my current mortgage situation, this will improve to 25% of invested assets and support at least six years of living expenses. This number goes up to more than eight years when Roth IRA contributions are included.
Now lets address these questions one by one for an early retiree:
- Access to living expenses: You are going to need funds available to live on in the first five years. This assumes you decide to do a Roth IRA conversion ladder as the simplest way to access your retirement accounts prior to turning 59.5. So where can these living expenses come from? A regular brokerage/savings accounts, existing Roth IRA contributions, and any deferred distributions from an HSA account.
- What is your tax rate today? You should be able to calculate an all-in tax rate (total taxes paid divided by adjusted gross income) and your marginal tax rate, which is the last published bracket you pay taxes in. The higher the rate, the more benefit you receive by putting money in. Someone who’s in the 10% or 15% tax bracket may want to add more to their regular accounts before fully maximizing all retirement vehicles available to them. Consequently, someone who’s in a high federal and high state rate may be better off deferring a lot more in pre-tax accounts while taking some liquidity risk or even relying on a home equity line of credit as their emergency fund.
- What do you think your tax rate will be when you stop working? This is the big unknown. In general early retirees live on less than they earned in their working years. This allows future taxes to be lower. What is your family situation? If you have children or plan on having kids in in early retirement, the tax benefits improve. You may even be able to earn $100,000/year and not pay any taxes. You could also have a hobby that blows up into a real income but that would be a good problem.
- What is your state tax situation going to be? I’ve worked in states with and without an income tax. It changes the math some if you can earn income in a zero tax state but plan on moving to a state with income taxes in retirement. Side Note: We’ll probably be both a winner and loser in this scenario. I took a job and my last 4+ years of working at the highest income level I’ll earn have been in a state without income tax (don’t worry though, we still pay plenty of taxes – our property tax bill is well in excess of five figures). We’ve been able to grow our regular brokerage account quicker without the drag of state taxes. We plan on geoarbitraging to a lower cost of living area in retirement and that will come with state taxes on distributions from pre-tax accounts.
So what does this all mean for a potential early retiree? Set a target allocation that includes a percentage in pre-tax and post-tax accounts. We didn’t think about this allocation early in our investing career and missed out on some generational investment opportunities that required more in after-tax accounts. Then we built up our after-tax accounts up to 20% of our savings and it was still a bit too tight to be comfortable pulling the plug early. Decide on what the right allocation is for you then adjust your contributions occasionally to meet your goal.