The Importance of a Diversified Retirement Plan
Historically, financial professionals have used the analogy of a person sitting on a 3-legged stool to give their client a visual aid for retirement planning. The three legs of the stool represented the three sources of income in retirement: Social Security, pensions, and personal savings. In order to illustrate and stress the importance of having diverse sources of income during retirement, the professional would ask, “What would happen if that stool was missing a leg?” Unfortunately, employer-sponsored pension plans have become virtually non-existent over the past several decades, so most people will be missing this leg of the stool. Also, individuals have little control over growing their Social Security benefits, which will typically replace around 40% of pre-retirement income. This adds more pressure on people to grow their personal savings in order to have a strong financial foundation and enjoy the golden years of retirement stress free.
Personal savings refers to any assets that an individual has saved for retirement. This could range from a money market account at their local bank to a retirement account offered by their employer. Keep in mind that the type of account used for retirement savings could be just as important as what the savings are invested in.
When saving for retirement, it is best to start with accounts that are specifically designed for retirement, such as an employer sponsored retirement plan (401(k)) or an Individual Retirement Account (IRA). These qualified retirement accounts have preferential tax treatment as compared to non-qualified savings and brokerage accounts. However, for added flexibility in retirement and to minimize taxes and maximize income, we will focus on several instruments that are available to build both tax-deferred and tax-free personal savings, using the 3-legged stool model. We are rebuilding that stool.
For most, the first leg of their personal savings stool will consist of a tax-deferred retirement account such as a Traditional 401(k) or 403(b). It’s hard to argue with the benefits of these plans, especially if the employer fully or partially matches the employee contribution; that’s essentially free money. Also, saving is made easy since the contributions are taken automatically from the employee’s paycheck. These plans have contribution limits, for 2021 it is $19,500, and will increase to $20,500 for 2022. There is an additional catch-up contribution amount of $6,500 for those age 50 and over. Since the account is tax-deferred, every dollar of savings is put to work right away. Also, the pre-tax contributions lower current taxable income.
However, a 401(k) on its own might not fully support your retirement savings goals. The main drawback is income taxes. With a traditional 401(k), retirees owe taxes on the money that is withdrawn. This could have a negative effect if you are in a higher tax bracket in retirement than you are today. It is impossible to predict the tax environment the country will be in at that time. So, if all of your retirement savings are subject to an unknown future income tax rate, you run the risk of less purchasing power than was originally planned.
This leads us to the 2nd leg of the stool, a tax-free savings vehicle. A growing number of employers are offering a Roth 401(k) option. The Roth retirement account works in similar fashion to the Traditional 401(k). Contributions are made directly from the employee’s paycheck and the contribution limits are identical. The main difference is that withdrawals are tax-free with the Roth version. The tax-free feature will help the saved money stretch further during retirement compared to the Traditional 401(k).
Although not all employers offer retirement plans to their employees, there is always an option to save through an Individual Retirement Account (IRA). This is a decent alternative to employer-sponsored retirement savings and there are both Traditional and Roth versions. Anybody with earned income can make a non-deductible Traditional IRA contribution. Contributions may be deductible for low or moderate earners or those without access to workplace retirement accounts. However, a Roth IRA has income restrictions. Both types of IRA’s have the same contribution limits of $6,000 for 2021 and 2022. People aged 50 or older also have a $1,000 catch up contribution allowance.
Finally, the 3rd leg of the stool is a regular brokerage account. A brokerage account also has a built-in tax deferred feature when an investment is bought and held long term. Unlike a Traditional retirement account, the taxable event occurs when the investment is sold, not when cash is withdrawn. Taxes are due if the investment is sold at a gain. Any losses can offset gains to reduce capital gains tax that has accumulated. Another advantage of a brokerage account is that it is taxed at capital gains rates. In most cases the long-term capital gains rate of 15% is lower than an individual’s ordinary income tax rate.
So, when planning your retirement, keep in mind that a tax-deferred retirement account paired with a tax-free retirement account and a taxable brokerage account will create a well-balanced plan for a financially sound retirement. Having all three accounts introduces flexibility into your retirement plan. Over-reliance on any one type account has drawbacks. For example, we’ve seen situations where clients are totally reliant on tax-deferred accounts such that every unexpected expense raises their taxes. Also, since everyone’s financial and tax situation is different it is important to check with your tax professional for the option that best suits you.
Dan Krstevski, CFP®