Building After-Tax Floor and Upside into Your Savings Plan
Let’s assume you’re already contributing to your company sponsored plan—if not maxing it out, then saving at least 10% of your salary in a combination of your own plus any employer contributions. If you’re not, then set this up now. At the very least cover any employer contributions—it’s free money! This isn’t news, so let’s not belabor it.
Retirement savings in company plans works for many because it’s both easy to setup and it’s automatic, via payroll deduction. And it stays in the account, compounding, because it’s hard to get it out (paperwork, filings!) and it’s subject to a 10% penalty until after age 59-1/2 if you try to use it. You work, you get paid, your retirement account grows, and later on it’s there when you need it. Oh, and tax deductible, too. Easy enough.
So what’s next?
Before you start thinking about Roth retirement accounts, consider that many of us reach retirement with almost no after-tax taxable savings. Everything is in our 401(k) or IRA. Is this a problem?
It can be—taxes in retirement can be surprisingly high. If all of the savings you’ll use in retirement is tax-deferred, then every withdrawal you make for living expenses throughout your retirement is taxed as ordinary income. And the higher your income from withdrawals, the more of your Social Security benefits are taxed as well, up to 85%, increasing your marginal tax rate, perhaps above what it is now, as an increasing amount of your Social Security is added to your taxable income. After age 70-1/2, you are required to withdrawal an increasing amount each year from your deferred accounts, starting at about 3.65% of your balance, even if you don’t spend it—and that Required Minimum Distribution adds to your taxable income. The icing on the cake—higher ordinary income can also trigger higher Medicare premiums, which are means-tested based based on taxable income.
You can put your savings to work in three kinds of accounts:
1. Tax-deferred accounts, typically 401(k)s, 403(b)s, and traditional IRAs, which are the standard company sponsored or individual retirement account options. You deduct contributions from current income and pay taxes later on in retirement when you make withdrawals, which are required starting at age 70-1/2.
2. Tax-free accounts, typically Roth IRAs, Roth 401(k)s, HSAs for medical expenses (which can be ‘banked’ during your working years to offset withdrawals for other purposes after age 65), and 529 plans for college tuition, which, except for the growing number of Roth 401(k) plans, are set up and managed individually. You pay the tax up front since contributions are not deductible (except HSAs and 529s which make them double-good!), and make tax-free withdrawals that are not part of taxable income later on in retirement (or for tuition).
This makes sense if your current tax rate is low today and likely to be lower than your tax rate in retirement, so some judgment is needed. For many, taxes will be lower in retirement than while working. Often it makes better sense to convert from tax-deferred to tax-free accounts opportunistically in years when your income is low then to fund Roth accounts directly if you are in a high tax bracket—for example, if you’re between jobs or early in retirement. Think of Roths as a place to launder your tax-deferred savings when your tax rates are low. When they aren’t, think tax-deferred.
3. After-tax (Taxable) accounts, typically regular checking and savings accounts, bank money market funds and CDs, mutual fund accounts, and vanilla brokerage accounts. Any after-tax savings you have that is not in retirement accounts is in a taxable account. Since you’ve already paid the taxes on your savings in a taxable account, only capital gains and interest earned on the savings are taxable. Capital gains are taxed at a low 15% rate and only by the amount of taxable income in excess of $73,800 (joint filers); interest is taxed as ordinary income. Capital gains can make a taxable account practically tax-free.
Tax diversity is a good thing. Having savings in after-tax accounts can lower your need for taxable withdrawals from tax-deferred accounts, and can pay the taxes due on conversions from tax-deferred accounts to Roth tax-free accounts once your drop into a lower tax bracket after retirement.
So you should fund your tax-deferred retirement account and build after-tax savings in regular taxable accounts. After-tax savings will help you control your taxes in retirement and help you move large chunks of tax-deferred money into Roths opportunistically when your tax rates are lower than normal. You need both.
Building Your After-Tax Savings
The main problem with after-tax savings for most of us is that it’s too easy to spend. We carry our savings in a checking account, and it gets used up when big bills or splurges come along. It’s too easy to just write a check. It helps to build in some obstacle to treating after-tax savings like ready-cash, to make it more like retirement savings—which it is!
There are a couple ways to do this. My favorite is a long-term hedge against inflation using I Bonds. Buying I Bonds from the Treasury helps you build your retirement income floor, a rock solid base of annual income that should ultimately be large enough to cover your annual fixed expenses.
Floor is made up of three components—Social Security benefits, pensions, and “risk-free” savings. The risk-free part refers to U.S. Treasury securities—bills, notes, bonds, and TIPS, the closest things there are to a “risk-free” investments. That’s what makes them useful for building your income floor—they’ll be there when you need them.
For those with larger accounts, we typically build a ladder of TIPS (Treasury Inflation Protected Securities) bonds that mature each year of retirement with sufficient principal to cover that year’s expenses. TIPS are excellent long-term investments since they are adjusted twice a year for inflation. If inflation soars to 6% or 8%, the TIPS ladder expands 6% or 8% and your purchasing power stays more or less intact. But building a TIPS ladder requires some experience with bonds and investment practices. And right now, 5-year TIPS are paying a negative real yield.
Building After-Tax Floor—I Bonds to the Rescue
The Treasury also offers I Bonds, which almost anyone can use to build up a solid income floor for retirement, even starting out with small $25 purchases. I Bonds are inflation adjusted savings bonds that accrue inflation-adjusted interest which is paid when redeemed. You can only buy them in an after-tax TreasuryDirect account, so they are an excellent way to shelter away taxable savings, making it harder to spend it on current bills and splurges.
You can do it all online. Just go to TreasuryDirect.com and set up an account. You hook it up to your bank account or payroll vendor, and automatically fund it with after-tax payroll deductions or online transfers from you bank account. Getting your savings on autopilot is the first step.
Then once or twice a year (the rates reset May 1 and Nov. 1, so you have a chance to play the interest rate guessing game twice a year), you buy a maximum of $10,000 of I Bonds in your TD account. A married couple can invest a combined total of $20,000 a year (there is a way to get an additional $5,000 a year as part of your IRS tax refund; I Bond fans often send the IRS an $5,000 ‘overpayment’ of estimated tax in January to facilitate this). Over ten or twenty years, your principal can grow to be $100,000-200,000 (double for couples), plus inflation-adjusted annual interest. If inflation soars, so does the value of your I Bonds. For up to 30 years—bonds can be redeemed anytime and mature (stop paying new interest) after 30 years.
You can’t withdraw them until one year after purchase, and in the first five years, you forfeit 3 months interest, much like breaking a CD early. You have the option of paying the tax on the accrued interest each year as you go along, smoothing out the tax bill, or deferring it until you redeem the bond later on. No tax is due on the principal you invested—you already paid that tax!
In order to spend them, you need to redeem them and then withdraw the money from TreasuryDirect, so it’s a little more involved than writing a check on your checking account.
And that might just be the best thing about I Bonds (aside from the inflation protection!). It makes them that much harder to spend before you’ll need them to fund your income floor in retirement.
Until Nov. 1, I Bonds are paying 1.94%. The fixed rate (for the life of the bond) is .10% and the current inflation adjustment is .92%. After factoring (x2) the inflation rate for the full year, the current composite rate is 1.94%. If there is future deflation greater than .10%, the bond will pay no interest in that period, but never below 0%, so principal and accrued interest are protected during periods of deflation.
Contrast that with the 5-year TIPS which is currently paying a real negative -.05% + inflation adjustment. Yield to maturity for a 5-year TIPS is inflation minus .05%; the I Bond is inflation plus .10%. You need to buy a 7-year or 10-year TIPS to beat the current I Bond’s fixed rate.
Building After-Tax Upside with a Mutual Fund Account
You can also build taxable savings by setting up a mutual fund account at Vanguard or another mutual fund company. As with TreasuryDirect, link your mutual fund account to your bank account or payroll vendor with automatic payroll deduction or fund it with periodic online bank transfers. Automatic is best since your savings just keep silently growing.
If you are just starting out, at Vanguard, for example, set up an automatic recurring purchase from your incoming funds to buy shares in the Vanguard STAR fund, a 60/40 stock bond fund with a $1,000 minimum to start. When your account balance grows, you can move over to the Vanguard Balanced Index fund, with a $10,000 minimum and enjoy broader diversification. Once your account reaches $100,000 or so, you should develop a full Upside/Floor/Longevity/Reserves allocation based on your household balance sheet. The earlier you start this kind of long-term planning, the easier it is to create household security for later in life.
Meanwhile, the important thing is that with these two methods you are automatically building solid after-tax savings, invested for the long-term in your floor and upside, while making your savings more difficult to raid then if you left it in your checking account.
Somewhere down the road you will congratulate yourself that you were smart enough to set up these simple savings autopilots when you were otherwise too busy with family and career to pay much attention.
So go ahead, start now!
If you’d like more information about goals-based planning and lifecycle savings and investing, please feel free to contact me at email@example.com.
–Michael Lonier, RMA℠