For seasoned readers of our Notables newsletter, you have typically read about the economy, investing, or something else relatively technical that we attempt to break down. With so much ongoing news around inflation, stock and bond prices, and the conflict in eastern Europe, we thought we’d focus on some more behavior aspects of financial planning for this month to give us a little break. We are going to try to focus on items that we have total control over rather than discuss larger macro issues with so much uncertainty. We’ll break these concepts down in general themes. Don’t worry, next month we’ll have a whole article on what’s going on in the markets. This will be a review for a lot of our planning clients!
Flexibility in Planning
How much money will you need in retirement? Will tax rates be higher or lower in retirement? Are we going to need to account for a sustained long-term care expense? What if we hate our current job and want to take some time off? Although we can estimate all of the above, there are a lot of variabilities in someone’s life. We can pretty much guarantee that not everything is going to go to plan. With this being true, it’s important to build as much flexibility into our plans as possible and make sure we have enough room to adjust as we go. We want to be ready for as much uncertainty as possible and have a plan in place for each event. One of the main techniques we use it to help position clients to be more flexible is through investing in different types of assets through their plan. We’ve discussed the benefits of investing in a diversified portfolio. It is also important to have a diversified breakdown of different types of assets in different tax buckets. In the business, we call this asset location. Each one of these asset locations have different tax treatments. They are all located within what commonly referred to as the Tax Triangle.
The Tax Triangle
What makes up the Tax Triangle? It’s all of the different types of accounts that we hear about every day. Let’s briefly review:
- Pre-Tax: In a pre-tax account, we get a tax deduction on any contributions we make today. We’ll pay these taxes when we take the money out…typically in retirement. We are also taxed on any growth in these accounts when we take a distribution. 401(k)s, 403(b)s, 457 plans, and Traditional IRAs are all types of pre-tax accounts.
- Tax-Free: With tax-free accounts, we use money that we’ve already been taxed on and contribute them to the account. When we take a distribution, usually in retirement, we do not pay any additional taxes on any growth. The amount we take out in retirement does not have any effect on our taxable income. Roth IRAs are examples of tax-free accounts.
- Taxable: What happens if we need to fund a goal prior to retirement? What if we’d like to buy a second home or business? Taxable accounts can provide the most flexibility in a plan. We invest using money that we’ve already been taxed on. When we sell the investments, we either pay taxes on the gains or use a loss to potentially offset other gains or taxes in the current year. As long as we hold the assets for a year, we will pay a potentially lower tax rate on any capital gains. We sometimes refer to these accounts as a non-retirement account.
- Bonus: The Health Savings Account (HSA): Although most triangles have three points, our triangle has another bonus point…the HSA! As long as we follow all the rules and use any proceeds for a qualified medical expense, HSAs allow us the benefits of a pre-tax account (lowers income by being tax deductible) and tax-free accounts (gains are not taxed when distributed). If you haven’t heard it by now, we love HSAs. We often recommend clients avoid using the account for any current medical expenses and allow the invested assets to grow.
With so much uncertainty, having a nice balance between these different types of accounts allow us to be more flexible. In any one year as things change with income and other aspects, we might change the way we save in the different types of accounts to take opportunities as we go. For example: if we do not expect as much income in one year and we expect to be at a lower marginal tax rate, we might suggest contributing more to a tax-free account while in a high-income year, we might suggest a heavier contribution to pre-tax.
When we start planning work with clients, we often see folks heavily contributing to their retirement accounts (pre-tax and tax-free). Clearly, we love this! Saving for retirement is one of the most important parts of our jobs. On the other hand, for a lot of clients, we also like to balance these contributions to taxable savings. We find that clients often have significant goals prior to retirement that will need to be funded. We can accomplish this through taxable savings while continuing to save for retirement.
Having options and flexibility usually provides us with the highest probability of success. In a future article, we’ll discuss some of the ways we can make sure we are prioritizing saving. Easier said than done, right? Also, make sure to listen to the audio version for some hints for parents with kids who are taking on summer jobs!