As a financial planner, I see a wide range of scenarios in the plans that we do for people. One day, we may be developing a plan for someone in their mid-30’s, in their wealth development phase, and needs to chart a course of prudent long-term saving and investing. The next day we may be working with a couple who is ten years into retirement and wants to ensure the savings they’ve worked hard for all their life will sustain their lifestyle and hopefully provide some benefit to the next generation after they pass.
The needs, dreams, wishes, and goals of the individuals going through the financial planning journey range across the spectrum. However, there is one thing that nearly everyone going through the planning process seems to agree on: they would love to pay fewer taxes. In fact, I’ve yet to meet the planning client who lists as one of their goals a deep desire to pay more tax! (As an aside, if this happens to be you, there’s no rule against sending the IRS a donation…I’m sure they’d find a use for it.)
One of the difficult concepts to grasp during financial planning can be the idea of total lifetime taxes paid rather than amounts paid in any one given year. However, approaching a plan from this perspective allows a family to review the implications of each of the planning decisions they make on their projected tax bracket and resulting tax liability in future years, at least based on the legislation we’re aware of today.
One of the most significant strategies affecting total lifetime taxes paid is usually asset location, especially at what time these assets are placed in these locations.
Deciding when and where to contribute funds to any particular type of account as well as when to shift your strategy could end up saving you significant sums over time. Below are a few simple illustrations of how this effect plays out across the Roth versus Traditional retirement account discussion. It’s worth noting that these scenarios have been oversimplified for illustrative purposes and deciding between these options in real life should be looked at as a part of your overall financial plan.
Assumptions for all
Taxable income in 2021: $200,000
Tax bracket 2021: 24%, married filing jointly
Retirement tax bracket (estimated at today’s brackets): 12%
Gains and withdraws 3% of the contributed amount annually in retirement for 25 years
The amount remaining at end of life is simply the contributed amount that is passed to heirs who are in the 24% bracket
Richardson — the Roth Savers: The Richardson family have read many a personal finance article stating the wonders of saving in a Roth account and continue to contribute all of their retirement savings to these accounts, eventually having saved $1,000,000 to their Roth over time.
Total Contributions: $1,315,789
Taxes Paid on Contributions: $315,789
Net Contributed: $1,000,000
Taxes Paid on Withdraws: $0 (No tax on Roth withdraws in retirement)
Taxes Paid by Heirs: $0 (Heirs don’t pay tax on inherited Roth accounts)
Total Taxes: $315,789
Thompson — the Traditional Savers: The Thompson family value paying as little as possible in taxes today as they feel they already pay “too much” in taxes. They’ve been directing all of their retirement savings to traditional retirement accounts as they are confident that they’ll be in a low enough bracket in retirement to make this strategy worthwhile.
Total Contributions: $1,315,789
Taxes Paid on Contributions: $0
Net Contributed: $1,315,789
Taxes Paid on Withdraws: $118,419 (12% rate on $39,473/yr withdrawn)
Taxes Paid by Heirs: $315,789 (24% on remaining amount at death)
Total Taxes: $434,210
Clements — the Converters: The Clements value deducting as much from their taxable income now as they, like the Thompson family, believe this will benefit them when they’re in a lower tax bracket in retirement. However, they also don’t want to burden their heirs with high taxable distributions, likely during their high-income years in life. Therefore, the Clements decide to save in traditional retirement accounts while working and convert these funds during retirement up to the top of their 12% bracket, managing to convert the entire amount by fifteen years after they retire.
Total Contributions: $1,315,789
Taxes Paid on Contributions: $0
Net Contributed: $1,315,789
Taxes Paid on Withdraws: $71,051 (12% rate on $39,473/yr or 3% of withdrawn over 15 years)
Taxes Paid on Conversion: $157,894 (12% rate on $1,315,789, over 15 years)
Taxes Paid by Heirs: $0 (Heirs don’t pay tax on inherited Roth accounts)
Total Taxes: $228,945
In this simplified example, the gross contribution amounts were the same but the strategies and resulting total taxes paid varied widely. If you’re still following along the resulting total taxes for each scenario were:
Total Tax Paid Richardson Family: $315,789 Thompson Family: $434,210 Clements Family: $228,945
There are plenty of other variables and scenarios to keep in mind for each of these illustrations. For instance, a few of the variables a planner would review and assess are: tax-deferred employer contributions, required minimum distributions, tax law changes, inflation assumptions, other retirement income, available tax deductions, and the result of potentially ending up in a higher than expected tax bracket in any given year, among other areas of the individual’s financial plan.
However, even this simple illustration demonstrates the potentially wide range of value that planning can provide by not simply looking at the scenario and situation facing a family today but also looking further out on the time horizon to balance future expectations with today’s known variables.
The key takeaway here is that whether you are developing your own financial plan or engaging the assistance of a financial planning professional, it’s important to continually review how your plan looks to fulfill the various goals you have for the financial journey ahead.