Imagine you’re retired and living on $100,000 a year. Do you think it matters where the $100,000 comes from? Would it make a difference if the source was all in a 401(k) or a standard brokerage account? Does part of the money come from a pension or Social Security? Or do you have a Roth IRA? Well, some might think the only thing that matters is the amount and not the source. However, I’ll argue it’s not just the $100,000 net to focus on, but rather the gross amount that needs to be withdrawn to net out $100,000. In other words, the source matters. Interested in learning more?
Let's start with a couple examples:
- Example 1: Back to my example above, if a client had all of their investable assets in their company sponsored 401(k) plan and they chose to live on $100,000 a year, they would need to gross that up to account for their federal and potential state income tax.
- Example 2: Let’s imagine a second person who was also retired and living on $100,000 per year, but they have money split between the 401(k), a brokerage account with after-tax dollars, and some money in tax exempt municipal bonds and a Roth IRA. Though every person’s tax situation is different, this person is going to withdraw fewer gross dollars to net the same $100,000 because he or she can draw from sources with different tax attributes.
Enter what I call the Tax Control Triangle
The reason the person in the second example will withdraw less on a gross basis to net the $100,00 is that they have money invested in accounts with different tax rules. These different ways to invest are illustrated by the three points of the Tax Control Triangle.
- On the lower right of the triangle are accounts where money is invested on a pre-tax basis. Examples of this would be a 401(k), 403(b) or a Traditional IRA. This money was deposited pre-tax and grows tax-deferred, such that none of the balance has ever been taxed. When you withdraw from these (as the arrow indicates going into the center of the triangle) you’ll have to pay INCOME tax on the full amount withdrawn. Of course, the rate of income tax will depend on current tax rates and the amount that you withdraw. And if you live in a state with state income tax, you’ll need to consider that as well. So, back to the first example of the $100,000 retiree, they have to withdraw a gross amount that is sufficient to net $100,000 after taxes.
- The bottom left point of the triangle represents accounts where money is invested on an after-tax basis. This means you’ve already paid income taxes before you made a deposit. A few examples are savings accounts, CDs and brokerage accounts where you own stocks, bonds, mutual funds and ETFs etc. In these examples, when you make a withdrawal (as the arrow going to the center indicates) you can be taxed a few ways depending on the investment. This can include ordinary income like interest and dividends or capital gains. The rate of taxation will depend on current tax rates, the amount that you’re withdrawing and the amount of gain on the investments. Again, if you live in a state with state-level income tax, you’ll have that to factor in. But in this case, you have more influence or control than the pre-tax investments detailed on the bottom right of the triangle.
- The top of the triangle also represents accounts where money was invested on an after-tax basis, but in this case, the withdrawals can be done tax-free. This will include Roth IRAs, cash value of life insurance policies and municipal bonds. An investor who owns any of these can withdraw money on a tax-free basis.
All three points of the triangle have their merits. One might argue that saving pre-tax is the best, but keep in mind that there are rules to access these funds, and, in most cases, you can’t touch those dollars in a 401(k), 403(b) or IRA until age 59 ½ without penalty. Another person might forego the pre-tax savings and put their money in after-tax vehicles. Or they may have goals to fund that occur prior to being 59 ½ so they need that liquidity. But in doing so, they had to pay income taxes first and as such, they have less to invest.
In most cases, it makes sense to diversify and have money in the various points of the triangle. This provides the most amount of control. You control the taxation when you invest in these various accounts and you create more control over tax exposure when you begin to take distributions.
Our clients tend to have assets in all three parts of the triangle, and a valuable part of working with a knowledgeable and skilled financial planner is having the assistance to know which accounts to withdraw from and in what proportion to try to generate tax efficiency. If you would like to learn more about the Tax Control Triangle and other strategies, I suggest you reach out to us.