Thank you for joining me again for the Telos Financial blog. The purpose of the blog is to introduce financial planning topics to help educate. I want to start discussions about important financial topics that will educate, benefit, and improve your financial life. Ultimately, to help you focus on your telos.
The title of this blog post may create some confusion. It isn’t a question of who should hold your investments or should you bury your money in the yard or put it in the mattress; it’s a question of how much of each tax status should you have assets be invested. Confused already? Great! Let’s dive in. . .
This is known as asset location and it’s one of my favorite topics to discuss and I think it’s an underappreciated area by most investors. It’s deciding how much savings should go to pre-tax accounts, post tax accounts, and tax-free accounts. There are many factors to consider in deciding this; many folks I talk with only consider or tend to focus on the current benefits and ignore the long-term ramifications. That is to say, they worry about how much they will pay in taxes today, which is one of the considerations, while neglecting future benefits. I believe the long-term ramifications of this are a much bigger consideration and should be weighted appropriately in this discussion.
There are a lot of rules that come into play in this discussion: income restrictions, age restrictions, & spending restrictions to name a few. I strongly urge you to consult a financial planner or tax professional before making any financial decisions.
There are two reasons I believe now is a great time to increase use tax of free accounts. First, as I’m sure you’re aware, 2018 federal income taxes were recently reduced; the argument to pay more taxes today (at a lower rate) by putting savings is after tax or tax-free accounts is stronger. One simple strategy is to calculate the amount of taxes you’ll save under the new tax cuts and move enough assets to offset it. The logic is similar to that for avoiding lifestyle creep; it’s maintaining lifestyle while improving your long term financial situation. The second reason is the congress, in the new tax legislation, issued clarification on a strategy for getting additional funds into a tax-free investment account known as a Backdoor Roth IRA. The strategy has been around for a while, but the ruling provided a green light around its use.
A key reason to utilize tax free savings is as an offset to their taxable income in retirement. For most families, their largest financial asset is their pretax retirement savings. Having a tax free and after-tax account will allow you to manage your taxes in retirement; this is something you can’t do if all of your savings are pretax. If your only savings are pretax, you are subject to tax rates at the time and future tax rates are anyone’s guess. This gives you some control over the unknown future tax rates by creating the ability to manage your future income. The main downside, of course, with tax free accounts is you have to pay the taxes now.
Some additional considerations with tax free savings accounts are limited liquidity and that they are by definition, tax free. As I mentioned, these accounts have a lot of additional rules, each set is specific to the account type, for how and when you can spend the money. You need to be mindful of these. Next, you will pay taxes when you earn the funds, but you never have to pay tax on the gains. There aren’t a lot of account types that support this and there are a lot of rules to follow to keep this status, but it’s really worth jumping through the hoops to have the tax-free earnings. Types of tax free savings accounts include accounts titled as Roth IRA, 529, or Roth 401k.
A key reason to utilize after tax savings is liquidity. This is less of a long-term consideration and more of an emergency fund and short to medium term goal bucket. The primary downside to these accounts is you have taxes annually on capital gains and dividends.
Secondary considerations with after tax savings accounts are temptation & taxes again. Because there are no age restrictions or penalties for taking these funds, it can be tempting to SPEND! SPEND! SPEND! Please don’t; unless it’s in your plan. Taxes again are a consideration, because in an ideal situation, the account keeps growing and you have the problem of it generating income you don’t need, have to pay tax on, and want to defer, but can’t. It’s a good problem to have, but a real problem and something I see quite a bit. Investment strategy can help mitigate this quite a bit, but you need to consult with your planner if it’s a concern. Types of after tax accounts would be an account titled in an individual’s name, titled as a TOD (Transfer on Death) account, or titled as a Trust account.
The pretax account, again the largest financial asset for most families, is a fabulous account and most should invest funds in these accounts. A key reason to utilize these is your assets grow tax free; because you are saving more money (the taxes you would’ve paid are now being invested), the compounding interest will be more and the account will grow more. The main downside to this account type is you have to pay ordinary income taxes when you withdraw funds.
Secondary considerations with the pretax account are limited liquidity and exceptions. These funds typically cannot be withdrawn until age 59 ½. Unless you’ve done in depth financial planning and have implemented a complicated strategy with your planner and accountant on board, you should assume when you invest in these accounts that you can’t spend the funds until then. That said, there are exceptions to the rules that can be of great benefit; should the circumstances allow. There are many types of pretax accounts, but examples include accounts titled as Traditional IRA, 401k, or 403b.
There are many other considerations, pros, cons, and sundry items that influence this balance and I always recommend talking with your financial planner before making these decisions.
Telos Financial is a fee based, holistic financial planning firm located in Plymouth, Michigan serving young professionals and families. Founded by Dennis LaVoy CFP®, CLU® in his tenth year as an advisor, Telos serves clients around Metro Detroit, Ann Arbor, and across the great United States of America.