Don't forget about the Taxable Investment Account!
Hello, and welcome back to Retirement Answers. My name is Jacob Duke, and I'm a certified financial planner based in Little Rock, Arkansas working with clients all throughout the South. And, today, I wanna talk about the taxable investment account, and this is something that I think is very important and often overlooked, especially for retirees as they begin to think about retirement. If you are close to retirement, most of your money is likely held within some sort of tax deferred account being an IRA or a traditional four zero one k or four zero three b, TSP, some sort of employer plan that's all tax deferred. Now I can't blame you for this.
Jacob:Right? Because whenever you started working, the only option that you had to save and invest in was in that employer plan, and the only option was to do it in a tax deferred manner. It wasn't until 1997 until the Roth IRA was actually started and implemented and much less started within your four zero one k plan. It took years for those four zero one k plans to actually adopt a Roth option into the plan before you could ever even use them. Right?
Jacob:So what I see is someone who works with a lot of retirees and pre retirees is that most of their savings for retirement and and just kinda their life savings in general is all in a tax deferred status. Now that's a great thing. It is hey. It has saved you taxes along the way to do that, but we're gonna run into some issues whenever we get close to retirement because of a couple different things. Number one, if you are younger than 59.5, you potentially run into some early distribution penalty issues if you're under that age limit.
Jacob:The other thing is that any dollar you take out of a tax deferred account is gonna be taxable in the year in which you take it out. So what can we do to help mitigate this tax issue whenever we're looking at our our retirement savings? Well, a couple things, especially if you're still working. Number one, we want to begin to kind of limit the number of dollars we actually contribute to the tax deferred side. Now this might be hard because you're likely in your highest earning years.
Jacob:Therefore, the tax deductions or lowering your income by putting in a tax deferred is gonna be taxable in the year in which you take it out. So that becomes an issue. And and to be honest with you, I've seen it in some situations where, more people pay more taxes in retirement, especially later retirement after RMDs kick in, but people can pay more taxes in retirement than they do while they are still working, which is kind of mind boggling. Right? We we do not like the sound of that.
Jacob:So what can we do to help mitigate this tax issue, whenever we're looking at our retirement savings? Well, a couple things, especially if you're still working. Number one, we want to begin to kind of limit the number of dollars we actually contribute to the tax deferred side. Now this might be hard because you're likely in your highest earning years. Therefore, the tax deductions or lowering your income by putting in a tax deferred account, that actually helps you out because you're earning more than you ever have.
Jacob:Now I totally get that. And so it's gonna be hard to kinda get your mind around this. But what if we only contribute up to the match in your in your employer plan tax deferred, then everything else we can begin to save either into cash or into a taxable investment account? What this does is, yes, I understand you're giving up some tax elimination right now, but what you're doing is building out what I call tax diversification for the future. So if we begin to build out this tax diversified kind of different buckets of money, as we begin to think about retirement, what that does is it gives you flexibility and it gives you lower taxes throughout the rest of your life because you've got multiple different tax buckets to pull from as you are in retirement.
Jacob:So if we've got a million dollars in a tax deferred IRA and no dollars in cash or taxable accounts or Roth IRAs, well, every single dollar we take out of that tax deferred IRA for living expenses or just distributions in general while we're retired, every dollar is gonna be taxed. And so what if I said, hey, we've got $7.50 in this tax deferred account, but we've got 200 in a taxable account slash cash account and then, you know, 50 in a Roth IRA. Well, that changes the game just a little bit because you've got different sources of income to pull from and different tax statuses to pull from. So that is the main thing that I'm looking at whenever I start to think about, you know, should we contribute all of our money to tax deferred as we're getting close to retirement? Or should we start to think about that taxable account and tax free account in the Roth?
Jacob:Another thing we have to worry about contrary to retiring before 59.5 is RMDs that are, you know, right now, the way the legislation is written, those begin kicking in at 72. There is talk about increasing those to 75 or 73 or an older age because we are living longer. But RMDs are gonna be an issue for most people, especially married couples who a spouse predeceases the other and the surviving spouse actually lives for a long period of time. The reason why is what I call the widow's tax trap. What you've got is let's say your RMDs on your total combined accounts for an annual basis are going to be a 100,000 starting at 72.
Jacob:Well, the problem with this is as soon as one spouse passes away, you then begin filing as a single filer and your tax brackets are compressed down to that single filer tax status. So what you have is you have the same amount of RMDs, a $100,000, but now you're gonna pay more tax on them because you are now a single filer rather than a married filing jointly filer. So we wanna make sure that we are looking at those things to make sure that we are not paying more tax than we otherwise would have to in the future. So the widow's tax trap is a real problem, and I've seen this play out in many people's lives. So what are some things that we can do?
Jacob:What are action items and steps that we can take to help mitigate these tax issues in the future? Number one, if you're still working, I encourage you to evaluate with a trusted adviser whether or not you should begin lowering how much you're contributing to your tax deferred employer plan and begin contributing to either Roths or that taxable investment account. And and to be honest with you, I'd probably do the taxable investment account. The reason being is that Roth IRA kinda loses its power the less time you invest in it. Right?
Jacob:That's a that's an account for early in your career, early in life where you can put money in it and pay the tax on it upfront and then let that money grow tax free for the rest of your life. So if you're doing that later in life, it kinda doesn't make as much sense. I would almost rather that money go into your tax taxable account. That way, you can use that money if and when you please, and it kinda just it makes more sense to do it at a later age. So that's number one.
Jacob:Think about maybe contributing to a taxable investment account rather than your employer plan above whatever the match is for you. Now secondly, if you are retired, we need to start looking at your income sources and perhaps look at doing Roth conversions. What this essentially is, and we'll talk more about this, is is you are electing to move money from a traditional IRA to a Roth IRA and pay tax on that money in in the year in which you do so. So it's kind of like a, hey. I'd rather pay my tax now in the future.
Jacob:And that's an active choice you have to make. There are steps you kinda have to go through to make sure you do that correctly. We obviously don't wanna be above the IRMA surcharges if you're on Medicare. We do not want to increase our taxability of our Social Security if that's possible. So kind of a lot of things would go into that Roth conversion decision and kinda where your income is coming from at the moment.
Jacob:So if you're retired, that's something I would for sure look at if you have really large tax deferred accounts. Hey. Should I be doing Roth conversions? Would they be beneficial for me or not? You know, how old am I?
Jacob:You know, what are my sources of income? All those different things because what a Roth conversion really comes down to is what is your next dollar taxed at? Right? So if you're making 25,000 of taxable dollars in retirement and you're living off other sources of income, then you have a lot of room to do Roth conversions. You're if you're actually if you have $80,000 of taxable income in retirement, well, it kind of squeezes how much you can actually convert, which this all goes back to, hey, we've gotta have those taxable investment accounts to live on, whether it be cash or just normal investments, because those are not taxable whenever we withdraw them, assuming a few things.
Jacob:So everything I say kind of comes with some nuances, but in general, if we can build up our after tax dollars and then maybe do some conversions whenever we are retired and not earning our normal income, we were while we were working, Those two things can help mitigate taxes in the future and kinda throughout your retirement for both yourself and then also if you're married, your spouse in the future after one of you passes because going back to what I mentioned earlier with the widow's tax trap. So don't forget about the taxable investment account. It's a valuable account that a lot of people overlook simply because it doesn't offer tax benefits, but what it offers and perhaps even more, important is flexibility. It gives you the options that you desire, and it allows you to do so with minimal taxes. So don't forget about that.
Jacob:Think about that. Consider it in your plan. I hope this has been helpful and informational. And, once again, you've been listening to Retirement Answers. My name is Jacob Duke, and we will see you in the next one.
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