Scott Burns for Dallas News writes: About $5,000 just fell into my lap. I already have savings for a
rainy day and beyond. I’m 59 1/2, so does it make good financial and tax
sense for me to do a 401(k) catch-up? I would use the $5,000 windfall
for living expenses while the same amount is being funneled from my
paychecks into my 401(k). Am I on to something, or is this an
ill-conceived notion?
J.H., Georgetown
This is something
you’ll have to work out with your tax accountant because the answer
depends on your current marginal tax rate while working and your future
marginal tax rate when retired.
When IRA accounts and 401(k)
accounts were created, everyone presumed that savers would put the money
aside and defer taxes at a high rate and would take money out later at a
lower tax rate. That, however, was before the taxation of Social
Security benefits pushed retirees into higher tax brackets.
Today,
many upper-middle-income workers are finding it no longer works that
way. The money they take out of these accounts is being taxed at the
same rate as, or a higher rate than, the rate when the money was saved.
The
biggest jump in marginal tax rate on the federal income tax is for
middle-income taxpayers. It happens when you move from the 15 percent
bracket to the 25 percent bracket. This year, that leap occurs at a
taxable income of $36,250 for a single worker or $72,500 on a joint
return. Your taxable income is the amount that remains after adjustments
for savings to tax-deferred accounts, deductions and personal
exemptions.
Another thing to consider is tax flexibility. Many
workers have every dime of their savings in qualified plans. This means
any money they need will create what our friends at the IRS call “a
taxable event.” If you build a reserve of after-tax money in a savings
account, you’ll have access to some money that won’t create a taxable
event. When it comes to tax planning, flexibility is very important.
My
wife and I are in our mid-60s and (mostly) retired. We have $2 million
in investment assets, so why wouldn’t we simply put half of our assets
in Vanguard’s Wellesley fund and the other half in Vanguard’s Wellington
fund? That would result in 50 percent equities and 50 percent
fixed-income — and very low expense ratios. Is this a foolish idea?
Note: We are both waiting until age 70 to take Social Security.
J.W., Clearwater, Fla.
That’s
not crazy or foolish at all. Indeed, I’ve suggested it a few times. It
would get you a 50/50 portfolio of equities and fixed income in two
five-star rated funds whose performance has been inside the top 10
percent over the last decade, measured against their peer funds. And
you’d get management at a near index fund cost level — 0.17 percent a
year for Wellington Admiral shares and 0.18 percent for Wellesley
Admiral shares.
You’d also get a bit more diversification than you
would with a pure Couch Potato portfolio since both funds have a small
allocation to non-U.S. equities. The international allocation would
average a bit more than 8 percent of the total portfolio. Except for
annual rebalancing (if you get around to it), this is a
set-it-and-forget-it plan.
There are fine hairs to split, however.
Since both funds are mixes of stocks and bonds, you would lose the
opportunity to do some tax and performance management. For instance, if
you had your investments divided between a pure equity fund and a pure
fixed-income fund, you could make withdrawals from the all-stock fund
after really good years and make withdrawals from the fixed-income fund
in years that were bad for equities.
Another fine hair is expense.
While the cost of your plan is minimal, some would suggest that using
two exchange-traded funds could reduce it still further, one for
equities, the other for fixed income. This would save another 0.10
percent or so.
Would it be worth it? Probably not, although you
could save about $2,000 per year on $2 million. To put that in
compelling practical terms, the saving would almost be enough to buy
about a case of Dom Perignon champagne at Costco.
Wednesday, December 18, 2013
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