I Read Academic Research So You Don't Have To: The Debate Over Tax Diversification

by Ann C. Logue

At this point, most investors can say it in their sleep: it’s imperative to use tax-deferred saving plans for the one-two punch of greater compound interest now, withdrawn at a lower tax bracket in your future retirement. The first part is unquestionably true: when it comes to compound interest, very small amounts add up over time. (Or, as the Wall Street maxim puts it, those who do not understand compound interest are doomed to pay it.)

But what about the second part? How do you know that you are going to be in a lower tax bracket when you retire? Anyone who can read the future that well is already retired. The December 2007 issue of The Journal of Financial Planning carried an interesting exposition of the topic in an article entitled “To Defer or Not to Defer: The Growing Debate over Tax Diversification”, by Jim Grote, CFP. (http://www.fpanet.org/journal/articles/2007_Issues/jfp1207-art1.cfm).

The point: the relentless pursuit of tax deferment by retirement savers may leave them with a large future tax bill and enormous paperwork requirements in retirement, coupled with a lack of flexibility beforehand. It can also cause inheritance tax headaches. Furthermore, there’s no evidence that anyone currently working, whether aged 21 or 64, will be paying a lower percentage in taxes in the future.

Right now, dividends and capital gains are taxed at 15%, while taxable income over $311,950 (for a married couple filing jointly) is taxed at 35%. These are really low rates; one of the more interesting parts of the article is a sidebar of historic tax rates, also available at http://www.truthandpolitics.org/top-rates. Compare that to 1980, when income over $215,400 was taxed at 70%, or to 1953, when income over $400,000 was taxed at 92%. Because the U.S. government is running a deficit and has an ongoing war with finance, taxes are likely to go up no matter which political party candidate wins the presidential election in November.

Tax rates aside, many retirees find that they need more money in the early years of their retirement, than they needed while they were working. Healthier retirees often spend their newfound time on expensive hobbies, exotic travel, or luxurious retirement houses. Some may take on part-time or consulting work to keep them busy and fund their activities. Whether the funds come from retirement plan savings or earned income, they’ll be taxable, quite possibly at the same rate as before retirement. That’s because qualified retirement plan earnings are taxed at ordinary income rates; a non-retirement account is taxed at the capital gains rate, currently less than half the marginal income rate. On an after-tax basis, money from qualified plans can cost more than money from taxable accounts.

The article recommends that financial planners (and hence, investors) back off from the assumption that taxes will always be lower in retirement. That’s an aggressive assumption over the entire period that someone could be retired. High net worth clients, who are least likely to be in a lower tax bracket, should diversify their investments by tax structure. By putting their savings in a mix of retirement and non-retirement assets, they’ll be able to take money from whatever source makes the most sense in any given year. If capital gains tax rates are low, they can draw more from the non-retirement account. If income tax rates are low, they can take money from a retirement source. Furthermore, investors should allocate funds between the two, to get the biggest bang for the tax dollar. Bonds, fixed-income mutual funds, and actively-traded stocks and stock funds should go into the tax-deferred retirement account; while index funds and buy-and-hold stocks are probably better held in taxable accounts.

Of course, not everyone is at the stage where there’s enough savings to worry about tax allocations. For many, the article says, the forced savings benefits of a 401(k) account are greater than any tax liabilities 20 or 30 years down the line. The article also notes, making investment decisions based only on their tax benefits is risky, because the people who make fiscal policy don’t care what you’ve done. Each year, April 15 brings its own challenges that may be harder to predict than the market itself.

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