Transcript:
Easan Arulanantham:
What are the three buckets of money? And why is it important to have a little bit of all of them?
Tom Vaughan:
Yeah, so this has come up a few times, because we’ve talked about it a few times. And so it keeps coming back around is, I think, a really good question. So the three buckets of money, as far as I’m concerned, are kind of taxable assets, you know, money might have in a brokerage account, individual account, whatever you want to call it. Everybody’s got different names for him, but just means that if you make a change inside that account, it’s taxable. And it can be a long term capital gain it held long enough, right. And then you’ve got really tax deferred accounts, which would be like a traditional IRA or a 401k, at work, or an 403 B’s, if your nonprofit, 450, sevens, if you’re at a municipality, you know, there’s quite a few of these different pieces that you can set up. And that grows tax deferred just means you don’t have to pay taxes on it, until you withdraw it, as you add money to it, you usually get a write off that money doesn’t end up on your tax return. So you know, those have some advantages. And then the last one is kind of a tax free growth. And specifically, what I’m thinking about there is the Roth IRA, or the Roth 401k. And so those you do not get a write off when you put the money in. So you have to put pay taxes on it first, before it goes in. And then, but it does go tax free, you know, for the rest of your life as far as that goes.
And so I think the advantages of having some balance amongst all three, there’s a whole bunch of issues, you know, having more taxable money, gives you the advantage to have more liquidity, because some of that money you’ve already paid taxes on. So if you need money to live off and retirement, you might be able to get some of that without any tax, because you paid tax on it a long time ago. And then any gains that you have are taxed at capital gains rates, if you’ve held on to for more than a year. And that can often be lower, or that is lower than ordinary income taxes for each person. So it’s cheaper tax wise. And so it just gives you the capability, somebody says to me, Hey, I wanna I got $100,000 left on my mortgage, I really want to pay it off. And, you know, I look at their assets, and they don’t have anything but a giant IRA tax deferred account. And so taking 100,000 out to pay out the mortgage, you’re gonna have to take out a huge dollar amount, maybe 175,000, depends on their other incomes. And so you’re gonna lose all this money to pay off the mortgage versus if I had that taxable account, I could take that out, and maybe pay off that mortgage satisfy that need, and have a lot lower taxes, because part of that is going to be, you know, already taxed money, and part of that as long term capital gain. So that’s the advantage of taxable tax deferred, you get the write off, which is great saves you money now, which is good. And it grows, tax deferred means that you can move stuff around. So we’re more active in our tax deferred accounts, for example, because we don’t have to put it on the tax return until you pull money out, right.
Disadvantage of tax deferred, is that there is a Required Minimum Distribution at 72. And I know a lot of people don’t pay a lot of attention to that. But I do have clients that are now having to do that, that are now you know, 7580 85 that have these big tax deferred accounts, and they’re having to pull a lot of money out, and it’s causing them, especially single clients to pay a lot more money for their so for their Medicare, you can end up pay two, three times more for Medicare, on top of being in a higher tax bracket. So that can be really unwieldly. And it is the one big asset I see all the time is all of this money in this tax deferred arena, I think people get carried away with that. And so then tax free like a Roth, of course, you know, if I can make 10% tax deferred versus 10%, tax free was a huge differential. So pay no tax on it, have a lot of liquidity can use that, at any point in time, pull money out of it without having to pay any taxes. You know, it’s a really, really powerful assets from flexibility standpoint. But also there’s no requirement of distribution at this point. So you know, you don’t have to take any money out. And that’s a great asset to let beneficiaries inherit, because they can keep it tax free. Maybe for life, depending on the beneficiary, or 10 years, again, depending on the beneficiary. That’s much better than letting your kids say, for example, inherit your giant IRA, that they’re going to have to take out over 10 years, and they’re going to get killed on taxes for that 10 year period. So all of those have pros and cons. And so one of the reasons to even keep tax deferred at all is because they might change the rules around the tax free side, right. So what you’re doing there is you’re diversifying the tax buckets, long term capital gains, ordinary tax gains tax free, right, all three of those are different tax treatments. If they change the rules, you have a distribution amongst those three. That seems very good to me, right? I mean, again, I’m on the other side of this my average clients 74. I’m dealing with these distributions. I’m watching what happens. I’m seeing how this works. And I’m seeing situations that are working better than others.
And so having those three buckets filled, you know, adequately, I think is a great thing. And so if you’re heading into retirement, pay attention, because this isn’t something you’re going to really notice as a problem until it’s too late. When you’re 7580 85. And you realize, oh, man, I put everything I had into that 401k, I probably should have put some money in taxable or put some money in the Roth 401k, or something along those lines and try to even this out, because now I’m getting hammered with this requirement and distribution. So that tax time bomb is something people just aren’t aware of. And that’s what we’re trying to talk about here.
Easan Arulanantham:
Yeah, and it’s a lot of the issues with Roth is it was available for a lot of people. That’s right now, your income when they were introduced, maybe your income was too much, or your company doesn’t have a Roth 401k. It’s only becoming kind of common, as you know, now, but you know, when you’re saving, maybe it’s all around?
Tom Vaughan:
That’s right.
Yeah, that current group of 75, 80, 85 year olds, they didn’t have a choice, they didn’t have a Roth, they do have a choice, now, and maybe even right after retirement to do some conversions, that a lot of people don’t know how that works. And now more and more people are getting more education about that. We talked about it constantly. You know, it doesn’t work for everybody, but it worked for a lot of people. And you’re exactly right, they didn’t have the options to put money into a Roth, for example, they probably did have the options of building up some taxable assets that probably should have happened, you know, maybe splitting a little bit of what they were saving into their 401k into something that was just a regular account, you know, that that could have happened, and a lot of people did. But you know, those types of things. I think it’s important for people to realize that there are three buckets, and there’s some advantages to filling out all three. Yeah, it’s an interesting conundrum. I will say, though, I’ve had a lot of conversations recently with people that do have Roth 401k is they didn’t know, didn’t even know what it was. So this that’s what this is about, you know, this show is to design people to have better retirements, go ask your company if you have a Roth 401k and consider what you should be doing there with your contribution, whether you should be adding some or all of your contribution to the Roth side of the 401k instead of the traditional side. And again, you and I have had those conversations with some of these clients and they just don’t know it exists. And so they go ask and it’s become more common. It’s not everywhere, but if it is, it’s worth looking into.