I’m not a maniac on avoiding taxes.? Living through the 80s and 90s, I saw many cases where people bought financial products that made them less after-tax money than many fully-taxable products would have made them.? Limited partnerships, life insurance, annuities, etc… I never saw the value in focusing on what the government would not get.? I was more focused on what I would get after taxes.
That doesn’t mean there aren’t clever strategies to avoid taxes, particularly if you are rich.? For the rich, taxes can be more of a negotiation.? How much work will the IRS have to go through in order to drag incremental dollars out of me?? (The same logic applies to corporations… I have seen it in action.)? Perhaps Leona Helmsley had a point, even if she overstated it, “Only the little people pay taxes.”? Maybe it should be, “Only the little people pay sticker price on taxes.”
Now, as for me, I have a Health Savings Account, a Rabbi Trust, IRAs for me and my wife, and a Rollover IRA from all of the jobs I have worked at.? It’s not as if I don’t try to manage my tax position.? But I don’t let it drive my investment decisions on its own.? I own my house free and clear.? I enjoy the benefits of flexibility in my finances; I have not used 529 plans, for example.? Where the investment fits my overall goals and objective, then I will consider how it affects my tax position.? In general, the higher dividend stocks go into my Rollover IRA, the lower dividend stocks into my taxable account.? I also gift appreciated stock through my taxable account to charity.
At present, I don’t own any munis.? That’s something I’ll have to revisit.
Now, here are two things to be careful about.? If IRAs grow too big there can be additional taxes on them.? I’m not too clear on the rules, perhaps readers can more fully flesh that out.? The other is that taxes are likely to be higher in the future, so avoiding taxes today may lead to more taxes tomorrow.? Also, I would question whether our government will honor the concept of a Roth IRA.? Social Security benefits were not supposed to be taxed, but today they are mostly taxed.? The same might happen to Roth IRAs at some point in time. ? Congress giveth, and Congress taketh away.
My closing point here would be to not overcommit to any single tax strategy.? Congress changes the rules so often, that it is difficult to make long term decisions.? Stay flexible, and avoid taxes where it does not compromise your flexibility.
Hello David,
You raise what I believe to be a critically important topic that most ignore – even in the advisory community. Tax diversification is just as important as investment diversification. While the babyboomers have done a horrid job on average, those who have done well are massively overweight assets in qualified plans. The lack of focus on this issue likely derives from ignorance but also the desire to avoid conflict. People are largely irrational when it comes to taxes and will fight tooth and nail to get a current deduction even if it is a bad long term decision.
We generally recommend people prioritize savings as follows:
1. Contribute up to the match of your employer in your 401k or similar account.
2. Maximize your contribution to a Roth IRA if you qualify.
3. Save in a taxable acccount with excess unless is it significant in which case max out the 401k in a balanced way.
Finally, regarding #2 there is a tax loophole for people who are above the Roth maximum levels of income. Between now and 2011 those people can contribute to non-deductible IRA’s and then convert them in 2010 or 2011 (I can’t remember the specifics off hand) to Roth IRA’s. I believe the tax burden of converting is spread over 2 years as well. This was part of the pension “reform” act passed last year. While not a huge dollar amount in aggregate it is a start for some to diversify their tax situation further.
David, re: Large IRAs, I don?t believe there are special taxes on large balances. There IS a problem in that when one reaches age 70.5, required minimum distributions (RMDs) must be taken and if the IRA is huge, the distributions put you in a high tax bracket in retirement. But in this regard IRAs are the same as other plans (not counting Roth IRAs, which don?t have RMDs until the retiree dies), except that if you?re working at age 70.5, you don?t have to take RMDs from the retirement plan for your current job.
A real problem for huge IRAs (or other qualified plans) comes at death: estate taxes kick in. If your qualified plan is the only liquid asset available to pay estate taxes, your heirs get hit with a taxation ?death spiral? ? funds withdrawn to pay estate tax are distributions and are thus taxed as income! There?s an income tax deduction for federal estate taxes paid in this scenario, but it doesn?t eliminate the impact entirely.
I agree with you that it?s wise not to be too committed to any one tax strategy, but consequently I think it?s a good idea for people who have pre-tax money in qualified retirement plans to also use Roth IRAs. 401(k)-type plans and deductible IRAs are most beneficial when tax rates are lower in retirement than while one is working; Roths are best when the opposite is true (as you note, does anyone expect lower tax rates in the future??). Having both types of plan permits some tax hedging, and since there are no Roth RMDs at 70.5 one?s flexibility is increased. I agree that Congress will likely fool with Roth IRA taxation, but it would be tough to totally eliminate the distinction between plans funded with before-tax dollars and those funded with after-tax dollars. More likely they?d cap the amount that can accumulate in a Roth, or include Roth assets in the determination of whether your SS benefits are taxed (or find some other scheme that only an accountant could love). It?s hard to imagine Roths becoming totally undesirable if used in combination with other plans.
Noticing James’s post, I want to add one caveat: Congress did provide the opportunity for high-income earners to do Roth conversions in 2010 and spread the tax due to conversion over two years. This was a sly move, though – under current law, in 2011 the 10% tax bracket is repealed and the top four tax brackets increase, so what appears to be a break will result in higher taxes in some cases.
Another note re: large IRAs, I also don’t think they are any extra taxes on large balances in IRAs. However, if you receive more than $1000 in “unrelated business taxable income (UBTI)” in your IRA, you do have to pay taxes on that income. I think people typically incur UBTI in their IRAs in the form of MLP distributions.
Tom Fisher made an excellent point regarding marginal tax rates. While it certainly makes the loop hole less desirable on the margin it doesn’t nullify the benefits in my opinion. As other posters have commented, the benefits of a Roth are significant over the long term and a 5-10% increase in marginal tax rates upon conversion don’t offset them. For example, who is to say that the highest bracket won’t be 50% in 10-15 years? Paying a bit more in 2011 to get some money into a Roth would help manage that risk – though taking back the tax free status of Roth assets is always a risk that simply cannot be managed…other than via the ballot box!
Well, I can’t offer anything specifically useful like the other experts here, but I can offer my favorite quip on tax deferred accounts: they are the roach motel for your money. It can check in, but it can’t check out.
Yep, I don’t like ’em.
1) Congress can unilaterally change the rules and we “little people” are without recourse.
2) For the last 10+ years long term capital gains have been less than “regular income” one pays on IRA withdrawals. And I don’t think that is going to change. IRA’s are just too big and juicy a target to tax.
I begrudgingly put into my 401k to maximize my employer’s match, but I’ll not go a penny more.
What bothers me most of all about taxes is if I do great one year and bad the next I don’t get to average the tax bill. They are always cherry picking my performance.
This is why I have readers. Taxes are not my specialty, so thanks for all of my commenters over the last two pieces in this series.