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Saving for Goals & Dreams vs Saving for Retirement… Its not the same!

May 13, 2021

Last weekend I was out with some friends, and caught up with somebody that I hadn’t seen for a while.  Come to find out he has since retired, and moved down south.  He is living his retirement dream.  We chatted about a multitude of topics, but he mentioned that taxes were killing him.  I was puzzled by this, based on my experience with clients this is not normally an issue.  But the underlying problem became apparent when he explained that he had just purchased more acreage surrounding his lot, and the multitude of toys that he bought.

I realized, ultimately that this not an investment problem, he has plenty of savings… It is an asset location problem. You see the benefit of 401k s and IRAs is that you can avoid paying taxes now, and use those funds later for income to subsidize your retirement. Social Security is a more efficient form of income in retirement because even in the worst case scenario only 85% of that income counts on your tax return.  Most people then subsidize their living expenses from monthly or annual IRA distributions.  

What is most interesting about retirement is this is the first time that you as an individual have tax control.  You are only paying taxes on what you withdraw and spend… Not on how much your money makes.  This seems great until you need money for those other things… 

You see, using your employer’s plan to do “All” of your investing seems like an easy solution, but if the tax code is around 6,500 pages long, easy solutions are not really realistic.  If I have learned anything over the years, putting dollars into an account without understanding how it will be used and taxed, is like playing monopoly and not knowing that you get $200 to pass go. 

Down the road you may want to buy a RV, install a pool, pay for a wedding, or help a grandchild with college, or just buy a new bass boat.  Drawing from your retirement account to fund these dreams in many cases can have the exact opposite effect of what the intended purpose is, which is to mitigate taxes.  Taking an additional $100,000 from retirement increases the amount of income for the year by $100,000.  The following example will illustrate what I am talking about:

Husband and wife taxable social security amounts combined at $34,000, IRA distributions 80,000. 

Total income 114,000

Calculated marginal Tax rate 22%

Total Federal Tax Bill $10,632.

If we take this same example and add an additional 100K of fun money, the marginal tax rate only increases 2% to 24%,  but it is on more total dollars.  Total Federal Tax bill is now $32,943.  So not even doubling your income caused a 3X increase in your tax bill.   I call this the fun tax, and there are ways to avoid it, but you have to “Plan” ahead.

Using ROTH or after tax money to fund these “Dreams” is much more efficient.  In the case of ROTH, the money is totally tax free once your oldest ROTH IRA account is aged 5 years and you are older than 59.5. 

In the case of after tax money, the capital gains rate is much more favorable on two fronts.  Even if we assume it is at a worst case 20% for long term gains, the tax only applies to gains.  So in our example an account that had invested $25,000 and grew to 100,000, would only have taxes applied to the $75,000 gain.  This tax is $15,000 (if current 15% rate applied… $11,250).  Last time I checked, $15,000 is less than the roughly $22,000 more that you would have to pay in taxes on your retirement account. These results can be made even better if we utilize some tax loss harvesting over the years, which helps to narrow the gain amount.

Investing money for the long haul is great!  Planning on how you are going to use that money to fund your retirement income and dreams is even better!  Please forward this link to someone you care about, as it just may save them thousands of dollars in taxes over their retirement.