LUTZ BUSINESS INSIGHTS
Tax Deferral: A Very Powerful Financial Planning Tool
NICK HALL, INVESTMENT ADVISER
PUBLISHED: MARCH 31, 2016
With the April tax deadline quickly approaching, taxes are on the minds of most investors. One thing I think we can all agree on is striving to pay Uncle Sam as little as possible in taxes, especially when it relates to our investment income. The more investors are able to minimize taxes, the larger the amount of their investments they will pocket. Tax deferred investments are one of the best tools currently available to aid in tax minimization. In addition to lowering current tax obligations, tax deferral allows investors to earn more interest on retirement assets and potentially reduces future tax obligations by shielding any dividends or capital gains until a later date.
Evaluating Tax Deferral Options
The retirement planning landscape has changed drastically over the last 30-40 years. Defined benefit plans, such as pensions, are extremely rare and have virtually become a thing of the past. Most workers today need to rely on self-funding their retirement goals. The inception of the 401(k)/403(b), traditional IRAs, and Roth IRAs have allowed Americans an avenue to fund and plan for future retirement goals. The government has placed retirement incentives in the tax code to urge people to save more into these types of retirement accounts. If you place money into a qualified retirement account like a traditional IRA or 401(k), the IRS may allow the amount of the contribution to be deducted from income. A couple, under the age of 50, has the ability to defer up to $18,000 each from their salary into a 401(k)/403(b) and an additional $5,500 to an IRA for the 2015 tax year (same for 2016). For a couple over the age of 50, the IRS allows for catch-up contributions and these contribution limits jump to $24,000 each and $6,500 each respectively.
Please keep in mind that the IRS does place an income limit for couples who are eligible for retirement plans at work on being able to make tax deductible IRA contributions. The current limits allow a full IRA deduction for both spouses if the combined modified adjusted gross income (AGI) is less than $98,000, and it gradually phases out until the AGI exceeds $118,000 at which point no deduction is allowed. However, the IRS does allow these couples to make Roth IRA contributions if their AGI is less than $193,000 (in 2015) or to make “nondeductible” IRA contributions regardless of income. One huge advantage of 401(k)s and 403(b)s compared to IRAs are that these income limits currently do not apply!
These provisions within the tax code allow investors to gain serious momentum into tax deferred vehicles. In addition to reducing current year income or getting money out of the tax system altogether using a Roth IRA, these retirement vehicles shield any dividends or capital gains from income year after year. As you will see, this can lead to significantly more interest and earnings on retirement assets over time.
The Power of Tax Deferral
So what is the long-term impact of funneling as much money as possible to tax deferred accounts for retirement? The answer simply can be summed up in one word—startling. The benefits of tax deferred investing versus taxable assets can be seen below:
This scenario shows the trajectory of two different accounts, the tax deferred investment plotted on the red line and the taxable investment plotted on the blue line. Both of these investors contributed $2,000 annually with an 8% total return, 3% of which came from income or dividends on the investment. For purposes of this scenario, this income was taxed at rate of 28% in the taxable account. Thus, the taxable account was adjusted to $1,440 contributions each year to account for these taxes. Conversely, that income was shielded from taxes in the tax deferred account. The difference over 40 years is remarkable—the investor with the tax-deferred assets had $518,113 while the investor with assets in the taxable account was left with $312,688, equating to a difference of over $205,000! The scenario then makes the comparison more realistic by simulating a withdrawal of both accounts at the appropriate tax rates as if the money would be used in retirement. Even when this is done, the investor who owned the tax deferred assets was left with $373,041 in after-tax assets versus the investor who owned taxable assets now totaling $294,405 in after-tax assets.
Tax deferral can potentially lower future tax obligations because taxes are due when the funds are withdrawn in retirement. Investors frequently have much lower income and are in lower tax brackets during retirement then in their working, higher income years. On the other side of the coin, Roth IRAs not only have tax-free growth but also are allowed to be distributed tax-free because contributions are made with after-tax dollars. One key point to consider is that taxable accounts are much more liquid than retirement accounts because investors can access the funds without penalty at any time. Conversely, investors are subject to an early distribution penalty on retirement accounts for any funds taken out before the age of 59 ½ (with very few exceptions). Having a mix of pre-tax (IRAs and 401(k), tax-free (Roth), and taxable assets allows an investor tremendous flexibility in retirement by being able to pull funds from different buckets depending on their income or tax situation in any given year.
Even for couples whose combined AGI exceeded $193,000 in 2015 and were shut out of deductible IRA or direct Roth IRA contributions, they can get additional funds in a tax deferred account outside of a retirement plan. These high income earners can make “nondeductible” IRA contributions with after-tax dollars. A major benefit of doing this is to get additional money in tax deferred accounts.
High income earners that make nondeductible IRA contributions may potentially subsequently convert these contributions to Roth IRAs. However, it is important to note that individuals must aggregate any outside pre-tax IRAs if they make a nondeductible IRA contribution and then try to convert it. For example, if an individual made a $5,500 nondeductible IRA contribution but had an existing traditional pre-tax IRA with $5,500 in it, he or she would only be able to convert 50% of the assets to the Roth IRA tax free while the remaining 50% is taxed at the ordinary income tax rate. Regardless of whether it makes sense to convert a nondeductible IRA contribution depending on the amount of existing pre-tax IRA assets, it may make sense from a “tax-shielding” standpoint to make the nondeductible IRA contribution to get basis in an IRA and shield these funds from dividend or capital gains taxes. When making nondeductible IRA contributions, investors should consult their accountant to make sure they are tracking the “basis” of the IRA contributions on Form 8606 if they are going to be combining these contributions with existing pre-tax contributions. This will avoid having clients pay taxes on these assets twice.
With any of these tax strategies, we would encourage clients to consult their accountant or CPA before implementing. As advisors and fiduciaries, one of our responsibilities is to try to minimize tax liability for our clients so they ultimately keep more of their returns. Tax deferral is one of the greatest weapons we have at our disposal to accomplish this objective and help clients achieve their financial goals.
Important Disclosure Information
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter
ABOUT THE AUTHOR
NICK HALL, CFP® + INVESTMENT ADVISER
Nick Hall is an Investment Adviser at Lutz Financial. With 10+ years of relevant experience, he specializes in creating thorough, adaptive financial plans and investment management strategies for high net-worth families. He lives in Omaha, NE, with his wife Kiley, and daughter Amelia.
AREAS OF FOCUS
- Comprehensive Financial Planning
- Investment Advisory Services
- Retirement Planning
- Income Tax Planning
- Social Security and Medicare Planning
- Investment Project Research
- High Net Worth Families
AFFILIATIONS AND CREDENTIALS
- Financial Planning Association, Member
- CERTIFIED FINANCIAL PLANNER™
- BSBA in Finance and Business Management, Eller College of Management - University of Arizona, Tuscon, AZ
- Mount Michael Benedictine, Alumni Board President
- Lutz Gives Back, Committee member
- United Way, Volunteer
- Salvation Army, Volunteer
- Omaha Home For Boys, Volunteer
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- New Tax Legislation and Individual Financial Planning Strategies
- The Ins and Outs of Health Savings Accounts (HSAs)
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