Wednesday, December 18, 2013

When saving more, always think about future tax rates

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.


Post a Comment