Saving for retirement in the most tax-efficient manner possible

October 5, 2017

This original article was written by Robert Powell for USAToday.

Decades ago, saving for retirement was fairly easy. You set aside 10% of your income in a taxable account. But over the years it’s become especially complicated given the many ways we can now save for retirement.

In addition to taxable accounts, we now have traditional IRAs, Roth IRAs, traditional 401(k)s, Roth 401(k)s, health savings accounts or HSAs, and all sorts of annuities including, qualifying longevity annuity contracts (QLACs) and deferred income annuities. Plus, retirees can generate income from any number of resources, such as a reverse mortgage or cash value life insurance, when the time comes to fund their living expenses.

To be sure, many experts are focused on helping retirees determine the most tax-efficient way to generate income in retirement from their various accounts, investments, and products, in combination with other sources such as earnings, Social Security, and, for some, a defined benefit plan.

But experts are starting to help pre-retirees learn how to prioritize their savings, learn how to save in the most tax-efficient way possible given all the various accounts, products, strategies and tactics.

And the reason is simple. Some dollars — given all the different ways you can save on a pre-tax and after-tax basis, given your marginal tax rate in the year you contribute to your retirement account and your withdrawal year tax rate — are worth more than others in retirement.

For instance, you might need to set aside twice as much money in a taxable account as you would in an HSA to generate the same amount of income in retirement. That’s because money goes into a taxable account after taxes and distributions are taxed at the capital gains rate. By contrast, money goes into an HSA pre-tax, grows tax-free, and withdrawals used for qualified medical expenses are tax-free.

“Unlike 401(k)s, HSAs are quadruple-tax advantaged,” said Keith Whitcomb, director of analytics at Perspective Partners. “There are no payroll taxes on employee contributions. The money contributed reduces taxable income. It grows tax-free. And withdrawals are tax-free as long as they’re used for qualified health expenses. This means HSAs can have a big impact on long-term retirement savings.”

Conventional thinking, however, is that HSAs are for high deductibles and that 401(k)s are for retirement, said Whitcomb. “This approach can be costly because paying for retirement medical expenses with 401(k) funds may be more expensive than using HSA funds,” he says. “For example, to get the same after-tax spendable amount in retirement, for every $1 deferred into an HSA it could take $1.44 deferred into a 401(k).”

Savings rules of thumb

There are, of course, some rules of thumb to follow when thinking about how best to prioritize your retirement savings. For instance, William Reichenstein, a professor at Baylor University and a principal with Social Security Solutions, says those choosing whether to save first in a Roth 401(k) or traditional 401(k) must compare their marginal tax rates in the contribution year and the withdrawal year.

Same marginal tax rate. If you have the same marginal tax rate in the contribution year and the withdrawal year it doesn’t much matter if you save in a Roth or traditional 401(k), according to Reichenstein.

High current marginal, low withdrawal marginal. If, however, you’ll have a lower marginal tax rate in retirement then in your contribution year, the tax-deferred accounts (a 401(k), traditional IRA, SEP-IRA) is the better savings vehicle, says Reichenstein.

Low current marginal, high withdrawal marginal. If you will have a lower marginal tax rate in contribution year than the withdrawal year then the Roth is the better savings vehicle, says Reichenstein. “The investor either pays taxes at this year’s (contribution year’s) tax rate or at the withdrawal year’s tax rate,” he says.

So, for instance, a new 2017 grad may be in the 10% tax bracket this year and that represents, he says, a great opportunity to invest in the Roth 401(k) instead of the 401(k) or the Roth IRA instead of the traditional IRA.

One key point

The key comparison is the marginal tax rates in the contribution year and withdrawal year,” notes Reichenstein. “In the work years — the contribution year — the marginal tax rate will likely be the same as the tax bracket. But the marginal tax rate in the withdrawal year could be 50% or 85% higher than the tax bracket due to taxation of Social Security benefits.”

Thus, he notes that a somewhat below-average to somewhat-above-average income retiree would likely be in the portion of income where each additional dollar withdrawn from the tax-deferred account, a 401(k) or IRA for instance, causes an extra $0.85 of Social Security benefits to be taxed.

“For many taxpayers, they would be in the low end of the 25% tax bracket,” says Reichenstein. “Thus, withdrawing say an extra $100 from the 401(k) may cause an extra $85 of Social Security benefits to be taxed, so taxable income rises by $185.”

Medicare Part B and Part D

Withdrawals from IRAS and 401(k) plans in retirement, which get taxed as ordinary income, could cause a wealthy investor to pay a higher Medicare Part b and D premium two years hence, which is effectively a tax on the wealthy, says Reichenstein.

“In short, the withdrawal year marginal tax rate could be higher than the tax bracket,” he says. “So, someone who expects to be in the same tax bracket in the contribution year and withdrawal year should probably save in the tax-exempt Roth.”

Reichenstein also notes that most preretirees have lots more money funds in tax-deferred accounts (TDAs) than in tax-exempt Roths. “If tax rates are raised down the road, it will hit the TDA withdrawals, but not the Roth withdrawals,” he says. “As a type of tax diversification, this suggests investing in the Roth — and paying taxes this year — to reduce the negative consequences of potential higher tax rates in the future on our large amount of TDA funds. Given the huge deficits, a general tax rate increase is certainly possible — even likely.”

Use HSA first if you have it

Of course, if have an HSA as well as a Roth and traditional 401(k), save there first. “The HSA offers the best of both account types,” says Reichenstein. “Contributions to it reduce taxable income like a tax-deferred account and withdrawals from it are tax free if used for qualified medical expenses.”

The right strategy. To be fair, the right savings strategy is based on one’s personal financial goals, and not just tax rates, as well as which investments and accounts and products you have access to.

For instance, Empower Retirement recently sought to determine which is better: saving money after taxes in a Roth 401(k) or pretax in a traditional 401(k). And what they found is this: “Most auto-enrolled participants are defaulted to pretax contributions. However, that may not be the ideal contribution type for many participants. Given the uncertainty of future tax rates, a personalized contribution strategy that considers age, income and earned income tax credit (EITC) is ideal for most participants because it reduces tax risk while improving retirement outcomes in most scenarios.”

Get help. To be fair, few have modeled how best to prioritize retirement savings if you have to factor in the vast array of products and accounts that you could use in addition to HSAs, Roths, and traditional 401(k)s.

Given that, experts suggest working with a financial adviser to personalize a plan that works for you. For some, saving in an HSA and Roth and using a reverse mortgage might create the most after-tax income. For others, adding a QLAC to the mix might make sense. But finding the right mix and savings order will require some number crunching. And leaving it to chance or just winging it could leave you short of the necessary funds you’ll need to fund your desired lifestyle in retirement.

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