In the world of finance, simplification is constantly advised. However, there is one aspect of a financial plan where it could pay to complicate things; a savings strategy. Most Americans do an excellent job of saving in two ways, building equity in their home and contributing to retirement accounts such as a 401(k). This is all thanks to foreclosures and payroll deductions. While the typical route may work for some, there are advantages to implementing a strategy that incorporates saving outside the traditional 401(k).
Owning a combination of tax deferred IRAs, tax free Roth IRAs, and post-tax Brokerage accounts (also referred to as taxable accounts) gives investors four distinct benefits.
Tax deferral is great, but unfortunately it doesn't last forever. Investing heavily into a tax deferred account typically comes with the belief that income taxes will be lower in retirement. While that may seem logical due to less income, it's possible tax rates increase in future years. Pay some tax now through Roth and Brokerage savings and avoid placing a large bet on future tax rates.
As perfectly illustrated with the passing the CARES Act, changes to tax laws can be substantial and abrupt. In just over a week, the President signed into law a 300 page bill that impacted a vast majority of Americans. Retirees were given an opportunity to drastically reduce their 2020 tax liability so long as they had non-retirement assets to draw from. 2020 alone has proven that by having savings spread across different account types, investors can quickly take advantage of changes to the tax code.
For those hoping to retire early or simply access savings, retirement account withdrawals and accessing home equity can be costly. It's important to save in accounts meant to be utilized for more than retirement. While brokerage accounts may not offer tax deferral benefits, they give individuals the flexibility to make withdrawals well before the golden age of 59.5. Home improvement, travel, and starting a business are just a few examples of why brokerage accounts should play a role in many financial plans.
In retirement years, income can be manipulated to provide sufficient cash flow while simultaneously taking advantage of low tax brackets. For example, say an individual retires at 60 and plans to live off $120,000 per year. By withdrawing $40,000 from Traditional IRAs and $80,000 from brokerage accounts or Roth IRAs, they can remain in the 12% tax bracket while meeting their withdrawal requirements. If the full amount were to come from Traditional IRAs, the withdrawal requirement would be closer to $150,000 (allowing for $30,000 to be withheld for taxes) landing them dangerously close to the 32% bracket. Yes this is an extreme simplification, but I'm trying to keep things to the point.
There are certainly instances where high income earners will want to reduce their AGI by contributing the maximum to traditional retirement accounts. Carefully review each years projected income to determine an appropriate savings strategy. Just remember that while retirement may be what we're working towards, there will always be new goals and obstacles along the way. If you're considering using account diversification to retire early, be sure to read our guide on six considerations.
Joe Crowley, CFP® is an Investment Advisor at Exchange Capital Management. The opinions expressed in this article are his own.