This is going to sound crazy, but maybe you should not be taking advantage of your 401(k). Maybe you should go ahead and pay taxes on your investments now, not later. Most of the people I come into contact with believe tax rates are going to increase. It’s hard to say, but you can’t argue that tax rates are historically low right now while government spending is historically high.
So, if we believe tax rates are going to go up, why would we want to pay taxes on our investments later? Maybe we should pay our taxes now. This is why we strongly recommend that clients take advantage of ROTH provisions in their retirement plans. ROTH allows you to pay taxes now on your deferral in order to achieve tax-free returns going forward.
But not everybody has access to or qualifies for ROTH contributions. ROTH conversions (where we convert tax-deferred money to ROTH) are a very important strategy to pursue as we proactively try to reduce the amount of tax-deferred money some of our clients hold going into retirement.
Another simple strategy that gets overlooked is to simply save and invest in a plain old, normal taxable account. Sure, you’ll have to pay taxes on capital gains and dividends, but depending on your tax situation, the tax rate on these investment gains could be lower than your ordinary income tax rate. Besides, these days with the aid of sophisticated trading software, we can be extremely efficient and strategic with these accounts.
Tax-loss harvesting, for example, used to be fairly manpower intensive, but now portfolio management software makes it really easy to implement. Using exchange-traded funds (ETF’s) also adds to the efficiency of non-qualified (meaning not in an IRA or 401(k)) accounts.
Should you ditch your 401(k)? Maybe that sounds a little extreme, but we can help you decide if using some different strategies would make sense for you. Using our planning software, we project your investments and taxes into the future. From there, we identify years where a ROTH conversion could make sense. We can also clearly see what your ordinary income tax rate could be in retirement and recommend adjustments to how you save now to maximize tax efficiency over your investing lifetime.
Any questions? What do you think, are tax rates going to go up? For those of you who have been around for a while, do you remember when tax rates were much higher? We’d love to hear from you!