Years ago when I was about to enter the working force and earn my first paycheck, I was engulfed with advice, recommendations, and ideas of what opportunities would become of my exciting endeavor. I remember one key item: It's not how much you make, it’s how much you save. This was an important aspect that my family instilled in me. It stuck with me for the rest of my working career and is consistent to the advice I share with my clients.
The fact is, the simple concept of saving smartly can create complex options that are often mismanaged.
I want to focus on traditional advice around savings. The problem I have with people giving advice whether it's on the radio, TV, or from family and friends is that each situation is different. You cannot take the advice that works for one individual and replicate the recommendation to another. Depending on their situation, one scenario can be very contradicting to another. (For related reading, see: Financial Planning Basics in 5 Steps.)
Don't Forget to Think About Taxes
Two popular retirement savings strategies are a traditional 401(k) and saving into a Roth IRA. For someone who is just starting out or who is nearing retirement, these two concepts are often compared. Let's shed insight into another perspective: taxes! Taxes play a huge role in the decision to save for retirement. The mistake I made working was when I was young was saving to a traditional 401(k) plan without looking at any other factors relating to the long-term financial effects. What I wish I was told was how our tax system works—I was only in the 15% tax bracket, so for every $100 I saved, I only got back $15 in federal funds.
As I continued my work career and started giving out financial planning advice, I realized I wasn’t the only one making this mistake. The important question is, What tax bracket do you see yourself in retirement? We have been told our whole life to defer, defer, defer! I think this advice is flawed. You must also look at how much you have saved in tax-deferred money. You should consider your income in retirement with Social Security, any pension, or other investments or retirement money that's tax-deferred. This can kick you into a higher tax bracket in retirement.
As I worked my way up in my professional career, I later realized that as I climbed, I was hitting higher tax brackets. The 15% didn’t look so bad anymore. In addition, the amount I saved seemed to triple as time went on. I now wish that was tax-free growth—in retirement, I will eventually be taking the money out of tax-deferred accounts at different tax rates. For a traditional tax-deferred retirement account, when you withdraw, you are taxed at ordinary income tax rates. Currently, the rates start at 10% and ends at 39.6%. (For related reading, see: 4 Keys to a Satisfying Retirement.)
Tax Bracket Hopping
The common thought is that in retirement, you will be in a lower tax bracket than you were during your working days. Depending on your situation, though, that might not be the case. Retirement income sources tend to be Social Security, pensions, rental income, and retirement accounts. With required minimum distributions (RMDs) and deductions decreasing for retirees, typically people are in the same—if not a higher—tax bracket during retirement.
Understanding your financial situation is important, especially when you're in your 20s and 30s. Typically, young workers are in lower tax brackets; Roth IRAs could be a great fit at that age. With those plans, you forfeit your tax deduction but the account grows tax-free for the rest of your life. You are also not forced to take your RMDs. This money also passes to your heirs tax-free.
The key is to understand your current tax situation and know what your tax situation will be in the future. If you current income is stable until retirement, then maybe you should analyze your income sources in retirement to make sure it's proper to defer now for a tax deduction. This does, however, put off the taxes until you take it out in retirement.
For those starting out with their first job and learning about their 401(k) options, they'll likely hear how they should save to it—it's a tax write-off. My argument is that the decision to defer depends solely on your tax situation. Making the initial decision could save tens or even hundreds of thousands of dollars throughout your life. Do not fall prey to the flawed advice that we all have gotten in the past. Depending on your financial and tax situation, you could be deferring your problem of how taxes become a real issue during your golden years. (For related reading, see: Turn Retirement Cash Flow Into Your Own Paycheck.)