------------------------------------------------------------------------------------------------------------------------
Welcome to My Personal Finance Journey! If you are new here, please read the "About" or "First-Time Visitor" pages to find out more about us. If you would like to receive free updates on articles like this by email, then sign up here or you can subscribe to the RSS feed. Also, check us out on Twitter or Facebook. Thanks for visiting! Keep on learning!
------------------------------------------------------------------------------------------------------------------------
For the past few years since finishing college, I have been somewhat bad in regard that I have been aggressively, but blindly, saving for the future/retirement.
What I mean by this is that I have been so focused on the input of saving money for retirement that I forgot to consider how the output would be affected when I went to withdraw those funds.
However, the good news is that the past month, I have been doing a lot of analysis of my current investment allocation location, learning about the withdrawal treatment rules of the accounts in which my funds are in, as well as learning about new options available to me to improve location distribution of my assets.
Going along with this effort to learn more about optimized location distribution of my retirement investments, I recently read the book, The New Three-Legged Stool: A Tax-Efficient Approach to Retirement Planning, by CFP and retirement planning specialist, Rick Rodgers.
If this is the first time you are hearing about the NEW Three-Legged Stool for Retirement (the old Three-Legged Stool, which consisted of Social Security and Pensions is no longer relevant, so we'll ignore that for now), it is a retirement planning concept that employs utilizing ALL three different types of investment accounts/locations (based on their tax treatment) shown below, in an effort to more efficiently prepare yourself financially for retirement:
Leg # 1 -Tax-Deferred Accounts (IRA, SEP IRA, Traditional IRA, Rollover IRA, Traditional 401(k), Annuities)
Leg # 2 - After Tax Accounts (taxable accounts - not tax-advantaged, including municipal bonds since income from that does increase your gross income, although that specific income is generally not taxed)
Leg # 3 - Tax-Free Accounts (Roth IRA, Roth 401k, cash-value life insurance)
Rodgers introduces a concept called the R/D Factor as a way to take withdrawals from these different accounts during retirement in a tax-efficient manner. In a nutshell, he advises that an efficient way to fund your retirement is to:
1) Take income during retirement from your accounts in such a way that 1/2 of your total income each year is taxable, and the other 1/2 is non-taxable.
2) When you reach retirement, the ideal goal is to have money saved up equally in all three legs.
I really liked the idea behind this because in my experience, it's always nice to have various options available to you when it comes to finances because you never know what the future will bring with tax law changes, etc.
However, one important question that was not expressly covered in the book is, "When you are saving for retirement, how much of your investments should be distributed in tax-free, after tax/taxable, and tax-deferred accounts, respectively?"
In searching around the Internet and reading through several of the investing strategy books I have accumulated the past few years, it seems that detailed guidance to this question is quite hard to find, although there was some good loose guidance on one Bogleheads thread I read based on other people's asset distribution.
In an effort to seek out some sort of answer to this question, I emailed Rick Rodgers directly. Essentially, what he recommends for his clients varies on a person-to-person basis. However, the distribution decision is generally based on the person's marginal tax bracket being at or above the 25% cutoff, or if it is lower. If you're not sure about what the tax brackets look like based on taxable income levels (note this is different than gross income or Adjusted Gross Income), take a look at this really good page that Mike Piper over at Oblivious Investor put together - Tax Brackets 2013.
To give us a starting point, listed below are the base/lowest taxable incomes that would qualify someone to start having to pay 25% income taxes, split up based on filing status. If you can get your taxable income $1 below these amounts, you will be in the the 15% tax bracket, so a pretty nice decrease!
Single - $36,251.
Married filing jointly - $72,501
Head of household - $48,601
Married filing separately - $36,251
From here, let's dig a little deeper to try to develop some real-life guidelines for how this rule of thumb would affect asset location distribution between the three "legs" discussed above:
Investment Distribution For People Who Are Already in the 15% or Lower Marginal Taxable Income Tax Bracket
The first possibility that we run in to in developing a set of working asset distribution guidelines is the case where someone is ABSOLUTELY certain that he or she will be in the 15% or lower marginal tax bracket.
To illustrate this situation with a few possible scenarios, this could be someone who files singly and only makes $35,000 per year in GROSS income, or if a young married couple was filing jointly and only one member of the family worked at a starting job out of college that earned $60,000 per year.
In this case, since you are in perhaps lowest tax bracket, you want to take advantage of the situation and pay taxes now instead of paying them during retirement. In Three-Legged Stool retirement language, you would want to emphasize tax-free and after-tax/taxable accounts.
To execute upon this strategy if I knew I was going to be in the 15% or lower tax bracket no matter what, I would take the following approach:
Contribute to your 401k (preferably, a Roth 401k - be sure to ask your employer about this newer option!), but only enough to get the free money match offered by your employer.
Max out your tax-free Roth IRA each year.
Invest an equivalent amount in after-tax/taxable accounts until you feel comfortable that you have enough to meet your pre-retirement needs.
If you have a traditional 401k/IRA that you have been contributing to (perhaps too much even in the past), continue to look for opportunities (particularly when the stock market is low) to rollover your tax-deferred investments to a Roth 401k/IRA option that allows you to pay taxes on it now vs. in the future when you are at a higher tax bracket.
Max out your Roth 401k. If your employer doesn't offer a Roth 401k option, don't invest further in your 401k. Invest in your taxable account instead.
Continue investing in your taxable account.
Basically, you want to take every opportunity you can to maximize the amount of investments you have in tax-free and taxable accounts!
Investment Distribution For People Who Have No Hope of Getting Below the 25% Marginal Tax Bracket
On the opposite end of the spectrum from the group of folks discussed above, we need to develop some general guidelines for higher-income earners that, despite the introduction of any amount of deductions they can reasonable execute, cannot reduce their overall taxable income below the 25% tax bracket income limits.
In this case, since you are in a medium-to-high tax bracket, you want to take advantage of the situation by deferring the payment of taxes until later when you can give yourself a chance at being in a lower tax bracket. In Three-Legged Stool retirement language, you would want to max out tax-deferred accounts and only start contributing excess amounts to after-tax and tax-free accounts once your tax-deferral options have been satisfied.
To execute upon this strategy if I knew I was going to be in the 25% or higher tax bracket no matter what, I would take the following approach:
Contribute to your traditional 401k up to the company matching level.
Contribute to and max out your traditional (pre-tax) IRA.
Invest an equivalent amount (as your annual IRA contribution) in after-tax/taxable accounts until you feel comfortable that you have enough to meet your pre-retirement needs.
Specifically, I would investigate tax-advantaged non-retirement investments such as tax-exempt municipal bond funds.
Continue funding and max out your traditional 401k.
Continue investing your tax-free and taxable account options
Possibly considering funding an annuity to further shelter short term earnings.
Consider funding a Roth IRA in some years, or if you don't qualify for a Roth IRA due to income restrictions, consider a backdoor Roth IRA conversion.
Investment Distribution For People Who are "Within Reach" of the 15% Marginal Tax Bracket
In between the two groups discussed above of higher income earners (definitely in the 25% tax bracket or above) and earners in the 10-15% tax bracket, we have a fascinating group that is sort of "on a fiscal fence." What makes them special is that they are looking at a significant decrease in taxes if they can get to their taxable income decreased slightly (through tax deductions) to the realm of the 15% tax bracket.
In terms of the investment accounts we're discussing here, I will estimate that being "within reach" of the 15% tax bracket is having a currently-estimated taxable income of $5,000-$10,000 more than the income limits described above for the break between tax brackets (so $36,251 + $5-10k for single filers and $72,501 + $5-10k for joint filers).
In this case, since you are within striking distance of entering the lowest tax bracket, you want to take advantage of the situation reduce your taxable income so you qualify for the lower tax level! In Three-Legged Stool retirement language, you would want to first emphasize tax-deferred accounts until you enter the 15% tax bracket, then switch to focusing solely on tax-free and after-tax/taxable accounts for the rest of the year.
To execute upon this strategy if I knew I was within reach of the 15% tax bracket, I would take the following approach:
Contribute my pre-tax 401k (NOT a Roth 401k) enough to get the free money match offered by your employer.
Continue contributing to a pre-tax 401k or traditional IRA until you have reduced your taxable income to qualify you for the 15% income tax bracket.
Now that you're paying very little in taxes, max out your tax-free Roth IRA each year.
Invest an equivalent amount in after-tax/taxable accounts until you feel comfortable that you have enough to meet your pre-retirement needs.
Max out your Roth 401k. If your employer doesn't offer a Roth 401k option, don't invest further in your 401k. Invest in your taxable account instead.
Do not focus on rolling over your tax-deferred investments to a Roth 401k/IRA option that allows you to pay taxes on it now vs. in the future since this would increase your taxable income and push you back up in to the 25% tax bracket you just tried so hard to leave!!!
Continue investing in your taxable account.
There are No Set Distributions Percentage Guidelines Prior to Retirement
One thing that I have definitely realized in this whole investigation, is that unlike asset allocation levels between stocks, bonds, REIT's, etc, there are really no firmly defined percentage guidelines in this game of how exactly much of your investments to locate in tax-free, taxable, and tax-deferred accounts prior to retirement (remember though - the ultimate goal is to have money saved up equally in all three legs when you hit retirement!).
I think the reasons for this lack of specificity are twofold: 1) this is something that people don't often think about since they get focused a lot of times on one "leg," and 2) things can vary so much depending on each person's need for money prior to retirement and their career track (earning levels).
Don't Forget the End Goal - At Retirement, Have a Balance Among All Three "Legs"
In an ideal world, investors would naturally pass through the different tax bracket stages discussed above as they progress in their career.
For example, a 22 year old that has just graduated from college and beginning their career will likely have a lower income. Thus, this person would focus their investing during their 20's in tax-free Roth and after-tax accounts. Then, when they are older and their income has gone up, they will scale back their tax-free investing to focus on building their tax-deferred base, throwing their remaining savings in to taxable accounts. The goal of this flow is to allow the tax-free/taxable accounts to compound longer to give them a chance to naturally be on par with the tax-deferred asset base. In this way, you naturally achieve the target 1/3 / 1/3 / 1/3 split of your assets among the three account types by the time you hit retirement.
This is how the Three-Legged Stool approach would work in an ideal world.
However, in the real world, I don't think it often happens that way. People make mistakes, perhaps investing too heavily in tax-deferred accounts (or not saving/investing any money at all because funds are tight and they are not wise with finances yet) in their early, low income days. Before you know it, you have been working for 10 years and are making over $100,000 per year. What happens then? Do you just forget about having any tax-free income during retirement because you missed your window at a lower tax bracket when you are younger to focus solely on tax-deferred investing?
Because mistakes are a part of life, there is likely to be a very unbalanced Three-Legged Stool if you aren't proactive in monitoring your asset distribution levels.
To prevent this imbalance at retirement age, a prudent course of action (that I will likely take - read more about my personal path forward below) is to calculate your % distribution in tax-free, taxable, and tax-deferred accounts each time you assess your portfolio's asset allocation levels for potential rebalancing.
I'd also recommend adding a line item indicating your current marginal tax bracket to whatever mechanism you decide to use for tracking your % distribution. This will help direct the flow of new money that becomes available for you to save.
Since there are no set % guidelines for what your specific distribution should look like prior to retirement, you will have to use some person discretion here. However, I honestly believe that people are intelligent, and simply by actively calculating your distribution each year or month, you will be able to gauge whether corrective actions need to be taken so that you gain a more ideal distribution for retirement.
To illustrate how this tracking/corrective action process would potentially work, let's consider a fictional 40 year old man named Bob. In the early part of his career, Bob was not very fiscally responsible with saving money in a Roth IRA and/or taxable accounts to take advantage of his low tax bracket.
He now makes $150,000 per year, putting him above the 15% tax bracket. In calculating his investment distribution among the three Legs, he sees that he has the following breakdown of assets: 5% in tax-free accounts, 40% in after-tax accounts, and 55% in tax-deferred accounts. From the investment distribution rules set forth above for people above the 15% tax bracket, Bob should technically be focusing his current investing in tax-deferred accounts. However, since he has such an imbalance in that his tax-free accounts are so low compared to the others, he would want to sacrifice some current tax savings to execute a backdoor Roth IRA conversion contribution in order for him to have some tax-free income to tap during retirement.
Overall, just be sure to remember that you should be getting closer and closer to achieving a 1/3 balance between all three legs as you get within say 3-5 years or so of retirement age!
Don't Sacrifice Access to Savings Before Retirement!
As I mentioned above and previous posts, regardless of if you're in a high or low current tax bracket, you don't want to go too crazy contributing to retirement accounts (where the money is locked up until you reach 59.5 years old) unless you feel comfortable you have enough money saved up in after-tax accounts first. This would be money that could be accessible if an emergency, planned expense, or other opportunity came up in the future.
In short, don't underestimate the power of having accessible money when putting together your Three-Legged Stool.
My Personal Three-Legged Stool Distribution Percentages and Path Forward
I just looked through my current investment holdings, and listed below is my distribution for tax-deferred, after-tax, and tax-free accounts:
Leg # 1 -Tax-Deferred Accounts
My tax-deferred accounts include a traditional (pre-tax) Individual 401k and a Rollover IRA (from 401k at my job before going to graduate school). Both of these are with Vanguard, in index mutual funds.
Current tax-deferred balances represent 38.1% of my total investments.
Leg # 3 - Tax-Free Accounts
My tax-free accounts consist solely of Roth IRA's. I have one at Vanguard which I am actively contributing to (have almost maxed it out for the year! hooray!) and one with Sharebuilder that I used when I first started investing, but no longer monitor (it holds mostly index ETFs).
Current tax-free balances represent 25.2% of my total investments.
Leg # 2 - After-Tax Accounts
I cover this bucket of accounts last because it essentially is my "other" category in that it represents the portion of my investments that are not in tax-advantaged accounts.
Current after-tax balances represent 36.7% of my total investments.
Truthfully, I was quite surprised when I calculated these percentages since even though there is some imbalance, I have pretty good representation in all three Legs. However, as I suspected/mentioned in my post about blindly saving for retirement, it does appear that the tax-deferred (401k/rollover IRA) bucket is the largest percentage of the three.
Nevertheless, it is clear in looking at these percentages that I have some room to improve in building up the tax-free account while I am in graduate school and WELL inside the 15% tax bracket, as I shared in my 2012 taxes review post the other day where I calculated that I only paid 14.6% of my overall income total taxes last year.
In an attempt to figure out a path forward for me, let's take a look at the action steps I listed out for folks in the 15% tax bracket above:
Contribute to your 401k (preferably, a Roth 401k - be sure to ask your employer about this newer option!), but only enough to get the free money match offered by your employer.
Graduate students don't get 401k's, let alone employer matches, so we can scratch this off the list!
Max out your tax-free Roth IRA each year.
I am well on the way to doing this. I should have this maxed out by the end of April 2013, so we can put a check mark next to this one!
Invest an equivalent amount in after-tax/taxable accounts until you feel comfortable that you have enough to meet your pre-retirement needs.
Even though I have enough readily accessible, liquid money saved for my forecasted cash needs for the next 1-2 years, something tells me that it would be beneficial to build this up further to meet un-expected needs, such as a house downpayment, buying a car, etc.
This additional savings would be a little further down the road than the extremely liquid funds I need to for example, pay my estimated taxes each year. However, I just need it to be available in the regard that it is not in a retirement account that is penalized for accessing if needed.
Because of these considerations, I believe my path forward will be to start committing my saved money to my taxable/after-tax Vanguard mutual fund account after I finish maxing out my Roth IRA for 2013. As far as an amount to save, I'll be shooting for an equivalent amount as I invested in my Roth IRA for 2013, $5,500.
If you have a traditional 401k/IRA that you have been contributing to (perhaps too much even in the past), continue to look for opportunities (particularly when the stock market is low) to rollover your tax-deferred investments to a Roth 401k/IRA option that allows you to pay taxes on it now vs. in the future when you are at a higher tax bracket.
Since the market is rather high right now, I don't think I will bother with doing a Roth conversion.
Max out your Roth 401k. If your employer doesn't offer a Roth 401k option, don't invest further in your 401k. Invest in your taxable account instead.
In lieu of Roth conversions, if I have more money to save after my planned after-tax savings above, I will start contributing to my Individual Self-Employed Roth 401k that I have just now set up.
Continue investing in your taxable account.
N/a since I have a Roth 401k option.
How about you all? Approximately what percentage of your investments are currently held in tax-free, after-tax, and tax-deferred accounts?
Do you think that you will be able to reach the 33% 3-way split target recommended by the time you reach retirement between the three Legs?
Share your experiences by commenting below!
***Photo courtesy of http://upload.wikimedia.org/wikipedia/commons/0/09/Liberty_-_Stool_Thebes_-_1884.jpg
