Every time you get a paycheck and contribute to your 401(k), your future tax burden increases. Not saying this is a bad thing, as tax deferred growth and the immediate tax savings it provides can be tremendously valuable. Now I won’t bore you on the history of 401(k)s, but we all know the older generations rely/relied on the 'three-legged stool' of pensions, Social Security and personal savings. With the phase-out of the traditional pension, I see more and more retirees with just personal savings and Social Security. And now when you ask younger generations what they expect out of social security, most know it’s a house of cards and realize that they’ll have to rely more on their personal savings.
This is a problem for two reasons:
The first reason is the burden of saving for retirement is becoming less and less your employer and the government's problem, and now shifting to the average American worker. This is a problem because not only do you have to be diligent in making monthly contributions, you also have to be smart in how you invest. Ultimately, it’s then up to you to create your own distribution plan.
The second problem is the increasing amount in 401(k)s and similar retirement plans. I would imagine Uncle Sam is salivating when he looks at that number and sees it’s well in the trillions. This huge number is rapidly growing, as it’s the main source of saving and makes up the majority of most people’s retirement assets. Not only do you have to plan efficiently to take distributions out of these plans, but you have to be aware of the tax implications as well. Where are future tax rates going? Considering the historical average and our current rates, not to mention the word socialism losing its stigma, I would assume up. (For related reading, see: Taxes on Retirement Assets: How to Pay Less.)
So let’s discuss two of the alternatives we like to look at to provide tax diversification for future retirement income.
The Roth 401(k) and Roth IRA are kind of the opposite of your traditional 401(k)s and IRAs. When you put money in, you have to pay tax on it, but when you take money out, it’s tax free. The reason why most people opt for the traditional plans is because it provides tax savings today, and most people like postponing their payments to Uncle Sam. There are two major downsides to these plans for the higher income earning demographic, which we define as singles making $100,000+ or married couples earning $150,000 or more. The first is that there are limits as to how much you can put in, and the second is if you’re in a higher tax bracket, it’s going to cost you a lot of money in upfront taxes.
My favorite way to contribute to these plans is using Roth Conversions, which means you convert a lump sum of traditional IRA money into a Roth IRA, and try to pay the taxes from your savings. My preferred time to do this is after retirement when your income is lower, and preferably between that date and the time you turn 70½, because that’s when Uncle Sam requires you to start taking money out, I call that the Roth Conversion Window. This allows us to convert potentially larger sums of money at potentially lower tax rates, while insulating you from future tax rate changes. (For more, see: Roth 401k vs. Roth IRA: Is One Better?)
There are two sneaky ways for higher income earners stash more money in Roths, Backdoor Roths and Deferred Roth Contributions. The Backdoor Roth means you contribute to a nondeductible IRA and immediately convert it over to a Roth. The deferred route means contributing after tax to your 401(k) and then shifting those contribution dollars into a Roth IRA when you roll the money out. The problem with these two options is, with the government catching on, these doors are likely to be closed in the near future.
This is a highly debated concept in the financial planning community, and it needs to be set up properly for it to be effective. I’ve run into a lot of financial planners who call these Section 7702 Plans, Tax Free Supplement Strategies, or something fancy like that to try to add pizzazz to it. The truth is its just life insurance. Under Section 7702 of the tax code, life insurance is allowed to accumulate tax deferred, and you’re allowed to take tax free loans from it if set up properly. If you Google 'Life Insurance Retirement Plan' you’ll get articles bashing it and articles praising it. The reality is it's just another tool in the toolbox. It may make sense for some, but for others it has no place in their retirement plan. I tend to see it as more of a fit for higher income earners with a decade or more until their planned retirement date. (For more, see: Strategies to Use Life Insurance for Retirement.)
The nice thing is that most high income earners I meet with already have a need for life insurance and are looking for a place to save extra dollars. Why not kill two birds with one stone and buy a policy that not only provides you with a death benefit, but also acts as a supplement to your 401(k) by providing the ability to take tax-free loans from it? Why not kill three birds with one stone and get the death benefit, tax-free loan income, and use an insurance policy that can provide extra income in the event of chronic or critical illness?
Just like the Roth, it is after tax money and there are cons with this strategy as well. The first is finding an unbiased financial advisor who can help determine if there’s a fit, and one who represents you and not a specific company. This is important because there are so many different factors that need to be tailored to your needs. Your average insurance salesman may not be in a position to compare different strategies from multiple companies, which is why I recommend talking with an independent retirement planning specialist, who represents you and not a specific company.
The moral of the story? Start thinking of ways to diversify your future tax burden, especially if the bulk of your money is tied up in pre-tax retirement plans. With the national debt over $19 trillion and the upcoming election, there’s no doubt in my mind that there is a target on the back of higher income earners and their retirement plans. The time to start diversifying with these strategies is now, because there is always the possibility of future legislative changes that won’t allow this. Based on legislative history with life insurance, the expectation is that the existing plans would be grandfathered in. In my opinion, the more you can pile into tax free accumulation vehicles, the better off you’ll be.