Take steps to make your retirement nest egg tax friendly

One of the questions that I’m often asked is, “How much do I need to save for retirement?” That’s a great question, however, a better one is, “How much should I save for retirement in tax-friendly vs. taxable investment accounts?”

Although neither question can be answered with a simple rule of thumb, the second one acknowledges a basic tenet of retirement planning. That is, asset location is an important, if not the most important, factor in determining the life of your retirement nest egg.

Tax deductions are tempting

Given our societal goal of immediate gratification, we generally favor investments that provide us with a current-year tax deduction. A common example of this is 401(k) plans. If you contribute $10,000 to your traditional 401(k) plan in 2015 and you’re in a 15% tax bracket, this will reduce your income-tax liability by $1,500, resulting in an after-tax cost of $8,500.

When making traditional 401(k) plan contributions, most people don’t think about the tax hit they will incur when they take distributions from their 401(k) plans.

Let’s assume that Lynn, the individual in the example above, recently graduated from college and continues to contribute $10,000 per year to her 401(k) plan for the next four years, resulting in contributions totaling $50,000. Let’s further assume that Lynn’s 401(k) plan is worth $100,000 when she retires, she’s in a 33% tax bracket, and she takes a distribution of 100% of the balance of her 401(k) plan. She will receive $67,000 after tax ($100,000 – $33,000).

Let’s suppose that, instead of contributing $10,000 per year for five years to a traditional 401(k) plan, Lynn contributes $8,500 per year for five years to a Roth 401(k) plan. Assuming the same investment allocation, Lynn’s contributions, which would total $42,500, would be worth $85,000 when she retires. Since Roth 401(k) plans aren’t subject to taxation, when Lynn takes a distribution of 100% of the balance of her plan, she will receive $85,000, or $18,000 more than she would receive from her traditional 401(k) plan.

Balance front-end tax savings with back-end tax liability

To further illustrate the importance of asset location when it comes to the life of your retirement nest egg, let’s assume that Lynn is a diligent saver. While she favors her traditional 401(k) plan due to the pretax deduction, Lynn recognizes the importance of having a diversified portfolio that includes tax-friendly investments when she retires. Consequently, she contributes proportionately throughout her career to her traditional 401(k) plan, her Roth 401(k) plan, and an individual non-retirement account based on her marginal tax rate.

Lynn’s total investment amounts and account values when she retires are as follows, assuming that the value of each account is twice the amount that she invested:

Traditional Roth Individual
401(k) 401(k) Account TOTALS
Investment 250,000 212,500 212,500 675,000
Value 500,000 425,000 425,000 1,350,000

Lynn’s federal income-tax liability attributable to the above account values and the net after-tax values of her accounts, assuming that she’s in a 33% income tax bracket, her capital gains rate is 15%, and her capital gains are also subject to the investment income tax of 3.8%, are as follows:

Traditional Roth Individual
401(k) 401(k) Account TOTALS
Tax Liability 165,000 0 39,950 204,950
Net Value 335,000 425,000 385,050 1,145,050

Despite the fact that (a) Lynn invested 85% of the amount she invested in her traditional 401(k) in her Roth 401(k) and individual investment accounts and (b) the value of Lynn’s Roth 401(k) and individual investment accounts are 85% of the value of her traditional 401(k) plan when she retires, the after-tax value of her traditional 401(k) account is $50,050 less than her individual account and $90,000 less than her Roth 401(k) account.

Had Lynn only invested in her traditional 401(k) plan, although it would be worth $1.5 million when she retires, the after-tax value would be $1,005,000, or $140,050 less than the total after-tax value of $1,145,050 of her three accounts. Lynn’s diversified approach enables her to extend the life of her retirement nest egg for an additional two years assuming her annual expenses are $70,000.

Tax diversification is essential

In the foregoing simplified examples, Lynn’s retirement income tax bracket of 33% was quite a bit higher than her initial employment tax bracket of 15%. In real life, while we can project, we don’t know what our actual tax bracket will be when we enter retirement; let alone what it will be throughout retirement. Sources and amounts of income, deductions, and tax laws are subject to change.

Given this reality, we need to know and understand the income-tax consequences of the distributions that we will receive from the investments we make today and diversify accordingly. This will increase the likelihood of retiring with a tax-friendly nest egg and extending the life of those assets.

By Robert Klein

Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.