Transcript:
Easan Arulanantham:
“So, in the past, we’ve talked about three buckets of money. You know: The taxable, tax-deferred, and tax free; and it’s best to have all of them. “Why is it so troublesome, the majority of my retirement money in a tax deferred accounts, like your IRA 401k?”
Tom Vaughan:
…This question, and this situation also comes out of our strategy sessions with our clients. And so one of the things you see oftentimes is that people have bought a house, they’ve made some money on the house, right? But they don’t want to sell it. So you know, the equity in the house is just there and for, either for beneficiaries, or they could use it at some point in time. And then they had a 401k at work, right? And they put the money in; they got a match. And they don’t have much money, except that. So if you take a look, they have a little bit of money in the bank, and a ton of money in a big IRA, and house equity. So, it creates some problems in several different areas. Number one, when they get to be 72, they’re going to be forced to take money out. And obviously, it’s a huge problem. It’s very inefficient, to have more taxable income on your tax return than you were using in any one year. So if you’re spending $75,000 a year, and all of a sudden, you’re putting $100,000 on your tax return, or $150,000, or $300,000, or $500,000, because you’re forced. So that’s one of the things to be careful with, with a giant amount of money in tax deferred assets, like a 401k, or IRA, there is a forced distributions called ‘Required Minimum Distribution.’ And it will drive you crazy if you have a lot of money there.
So sometimes by mitigating some of that, by spreading it out, I want to have some money in regular taxable accounts. So for example, you know, obviously, you’d have checking and savings and cash and those types of things. But you can have your same type investments, Vanguard and State Street and iShares, or whatever, in just a regular account. It could be a trust account, or individual account, a joint account, or you know, any of those types of things. And what that does is it gives you liquidity: Taxes are lower, because you already paid taxes on some of the money when it went in. And also it’s capital gains tax, instead of ordinary income, which is generally lower. So that’s very good, but it gives you the liquidity. And that liquidity gives you all kinds of power, in terms of what you can do going forward. So for example, if somebody wants to do a Roth conversion of some of those retirement assets, now they have some taxable money to use to pay the taxes, and they can fill that third bucket. And the third bucket I think, is maybe the most important, which is this tax free bucket, right? So in a perfect scenario, you’ve got some type of distribution across taxable, tax deferred, and tax-free. And man, if I’m heading into retirement, I’m really trying to make sure I’ve got a distribution across all three of those areas, because it just gives you flexibility.
The other thing that a lot of people probably don’t think about, but they can change tax laws really at any moment. And it might impact one category more than another. And so by having all three categories filled, you diversify the risk for tax law change going forward. So you know if you have everything in tax-free and they all of a sudden change their mind and make it taxable, it’s good thing that you had some tax deferred, good thing you had some taxable. If they change capital gains rates and make it ordinary income again, well, it’s a good thing you had tax-free, that type of thing. So, as tax laws change, you can make a really strong argument for having a distribution across those three areas. I would say this is the biggest falling down, that I see for people’s retirements, is not having an even distribution. It doesn’t have to be even, but not having a distribution across those three categories. And we do see a lot of people that have a big chunk of their money in that tax deferred area. And that is something that would be great. If you could go back in time and kind of rectify that. So it’s something, even if you’re retired, you can still work towards, you can still start building up those taxable assets, those types of things. So, it’s, it’s an interesting area, that’s for sure.
Easan Arulanantham:
Yeah, and another situation like we come across is, “say, I want to buy a car, but I’m retired. I want this nice car that I’ve always dreamed about. I have the money, but that money is in my retirement account. And say this car’s like $120,000 car, but it’s my dream car, and I want it, but then my income jumps $120,000? (Because …it’s considered my income.”)
Tom Vaughan:
Yep, yeah, so you got $120,000 on your tax return. And so you’re going to need to pull out even more to pay the taxes. And if you’re retired, that might jump you up in brackets on Medicare. Maybe you’re now paying more in Medicare, could impact you know, those other costs also, and all sudden $120,000 car end up costing you $175,000 after tax, versus having that $120,000 in a taxable account. Some of that money you pull out, you might have already paid taxes on, the rest is a gain. Especially if it’s over a one year gain, it will be a lot lower. It could be a 15% tax on that instead of you know, what would have been a much higher tax, as far as that goes. Have less chance of hitting your Medicare cost, if you are retired, for example, those types of things. Oftentimes, some people will look at borrowing the money, just to mitigate that as far as that goes. But then you run into other problems with borrowing and now you’ve got a payment, and if the markets all fall apart, you’ve got a payment. And so it’s hard to collapse your expenditures when some of them are fixed through payments. So that’s where yeah, exactly having some taxable assets to do that, gives you that flexibility without getting killed on taxes.