For those of you who are new to this concept, let me give you a quick overview of what I’m talking about when I talk about the tax deferred bucket.
In our retirement planning, we do a basic three bucket system. We have the taxable bucket. We then have the tax deferred bucket which is why you are here. Then we have that magical tax-free bucket that I will write about next week.
The tax deferred bucket is an interesting bucket because this is where 95% of America’s retirement assets are being held. There are over $22 trillion held inside of some type of tax deferred account.
When you compare that to the tax free bucket or assets that are being put into Roth IRAs, Roth conversions, or Roth 401Ks, there is only about 1 trillion dollars that’s being put in these tax free buckets. It’s a bucket that’s been filled for a long time.
The first tax deferred asset came about back quite a while ago. In 1974, the first individual retirement account was made available by the US government. You could contribute either 15% of your income, or $1500, whichever was the smaller amount. Then in 1978, the government brought forth the 401K and opened the doors to be able to put much more money into these accounts.
Why are these accounts getting funded so much? Well, a couple of reasons. One, because the government’s pushing us to put money into these, realizing that there is an asset that’s being built inside of the governmental system for them to take advantage of at some future date. Also, it’s because many of our advisors that we’ve met with have encouraged us to make these contributions.
If you sat down with the majority of CPAs, EAS, or even professional financial advisors, they’re going to tell you that you need to continue to find this tax deferred bucket. Why do they tell you that? Because you’re getting a current deduction, and it’s making them look good.
You come into the office, and you want to seek their advice to help you save money. They immediately tell you how you can put money into this tax deferred asset, you can get this great deduction, and they come out looking like heroes because they’ve been able to save you substantial amounts of money. Well, unfortunately, that is not the truth because what they got you was not a deduction; it was a tax deferral. A deduction is something that you get to take off your taxes and reduce the tax forever.
If you were to look at your personal tax return, and you had mortgage interest or property taxes and you were able to deduct these items, then that is a deduction. They reduce your tax; you never again have to pay anything to the government as a result of taking these deductions. However, when you put money in a tax deferred bucket, you’re getting to defer the taxes from today. Yes, you’re going to pay less tax today. But, you’re going to defer it to a future period of time when tax rates could be higher and even substantially higher than they are today.
This is what’s been happening for the last 50 years. This bucket has been continually overfunded. Well, if you’re in an environment where taxes are going down, it’s a great solution. For many years, this is what people expected to happen, especially if you go back to the 1970s.
When these were put into place, the highest marginal tax bracket was 70%. Well, no one assumed at that point in time, the taxes could ever get higher than that, and especially in retirement. These plans made a whole lot of sense. You fast forward to 2020.
We’re in some of the lowest tax rates that we’ve ever had. In fact, there’s only been four other times in the history of America where the taxes have been lower than they are today. Now we’re faced with a different situation or looking ahead, realizing that the money we’re putting into these accounts could create additional tax for us in the future.
When we talk about future taxes, and we talk about where people are going to be some point in the future, one of the things that many people kick back on, especially when I’m training CPAs, throughout the country, they will kick back and say, but I’ll be making less money in retirement, therefore, my tax rates should be lower. Well, let me address that in a couple of ways.
Number one, what we realize is that there’s one day in the week that we spend the majority of our money and what day in the week is that? That is Saturday. I know for me, it’s a big day. I’ve got six children. That’s the day we go to the movies, and they want to go out and eat. They need to get shopping done, so they can buy stuff for school or for themselves. Saturday’s is a big expense day for me and my family.
When you hit retirement, every day is going to be a Saturday. You have the freedom to be able to go shopping and to go out and eat with your spouse if you’re married. Go with your friends to golf or to do other activities that you may want to do. What we’re finding is that many people are not making any less money in retirement than they were during their working years. If they set up their planning correctly, they maintain the same lifestyle.
Number two is we find that many people have lost the deductions that they were taking during their working years, that even if their income is lower, their taxable income is not any lower because the deductions are gone. For most people, once they get into their 70s, they’re not going to have children still living in the home. If they are, they’re definitely not getting a deduction for them.
I had an interesting experience about two or three months ago when I was meeting with one of my clients. He’s been remarried ,and they were talking about one of his children. She was the stepmom to this son of my client. As we’re having this conversation, she brought up the fact there was time to have this son move out of the house. It moved back in a couple of years ago, and he had continued to live with them. She said he’s 40. He needs to get out of the house. Myclient responded back that the son was only 38.
Now, I don’t know about you. But if you’re 38, or if you’re 40, it’s time to get out on your own. And again, if you have children in this situation, yes, there are underlying circumstances that may cause it. Again, you’re not getting any additional benefits for them.
The other thing that you need to understand is that your deductions for home mortgage taxes, retirement plans, if you’ve been contributing throughout your working years to the tax deferred bucket, you are getting some type of deduction. When you get to retirement, you want to start pulling money out of this bucket, not putting money back into the bucket. As a result, these deductions are being lost. What we’re finding is that people are in the same tax bracket that they were during their working years.
The big issue comes down to whether or not you believe taxes will go up. When we go around the country and talk to thousands of CPAs, the overwhelming answer that we get is that, yes, they believe taxes are going to go up because of unfunded Social Security, Medicare, Medicaid, and the national debt that continues to grow on a daily basis, especially with everything we’re going through now. Taxes are going up. What you want to do is to transition money out of your tax deferred bucket into your tax-free bucket.
Many people struggle to understand how this can work. What I want to do is walk through an example where someone is taking money out of their tax deferred bucket, let’s say an IRA, and putting it into a Roth IRA. Most people assume, because of the way they do their math, that if you have a million dollar IRA, and let’s say you’re in a 30% tax bracket, if you pay the taxes today, so now you’ve only got 700,000 instead of a million dollars, but it’s now going to grow tax free, that you’ve lost some type of benefit that you had when the money was in the tax deferred account. This is not the case. The tax rates are the same today as they are in the future. When you get to the point of retirement, you’re going to have the exact same amount of money.
Let’s walk through the example and see if I can help you better understand what I’m talking about. You have a million dollars in a tax deferred account, tax rates are 30%, you decided to transition it over to a Roth IRA, and you pay the tax. Now in that account, you’ve got $700,000, comparing it to the million dollars that you have. Well, if you look at it in a 30% bracket, if the money were to stay in the tax deferred bucket, at some future point, you would have to pay 30%. You wouldn’t be left with $700,000.
The government’s your Silent Partner, and they’re waiting for that day when you pull the money out, so they can have their share. Well, let’s look at what happens when it grows. Let’s assume that the asset grows 10%. You have a tax deferred asset that’s worth a million dollars. It grows 10%, so now it’s worth $1,100,000. Then your tax-free asset, the Roth conversion, the assets $700,000 in gross to $770,000. Well, if you look at the math, we’ve got the same situation, the tax rates are the same. You pay your tax on the $1,100,000. You’ve just paid $330,000; you’re left with $770,000. If you look at your tax-free bucket, it’s the exact same amount of money.
The math is very simple. It works as far as the transition. The question you’ve got to ask yourself, are tax rates going up? If they are going up, I need to start making a transition to get money out of this tax deferred bucket.
One of the other questions we often get asked: Is there an amount that can be left in the tax deferred bucket, or do I need to empty it out completely? You can leave money in this bucket. Let’s talk about a few reasons why I believe money can be left in this taxable bucket.
The first reason is because there’s what we call a standard deduction. Now, if you were to look at that standard deduction, the current amount available to a regular person, if you are single is $12,400 per year, and if you’re married, that number is $24,800 a year. What happens when you reach age 65? There’s a bonus deduction that you get to take.
If you’re married, the amount is $1300 additional dollars for each spouse. And if you’re single, the amount is $1600, and $50. We go to a point where if you’re single, your deduction is $14,050. If you’re married, the deduction is $27,400. When you get into retirement, you should continue to have this deduction available to you. You can use that to offset required minimum distributions out of your tax deferred bucket.
Let’s assume that you had $500,000 in your tax deferred bucket. You had to take a 4% required minimum distributions, so you’ve got to take out two $20,000. Well, if you’re married, and you have a $27,400 standard deduction, that money has been able to come out without you paying any tax on it. What’s awesome about it is you did not pay any tax on the amount of money going in. You were able to take a deduction or a deferral on the money going into the tax deferred bucket. You’ve got a double benefit if you get the right amount into this bucket.
Well, the other thing you’ve got to be careful with, though, is provisional income. This is the income that the IRS uses to determine whether or not your Social Security is taxed, so what do they do? They take your taxable income at any tax-free municipal bond income and one half of your Social Security. If it exceeds certain limits, then your Social Security is going to be taxed.
You’ve got to make sure you do this calculation as well when you’re trying to determine how much is left inside of your tax deferred bucket because although you may be exempt from tax because of the standard deduction, you may end up getting tax taxed on a portion of your Social Security. The amount in the tax deferred bucket is going to vary. Unless you have a pension plan, there should still be an amount that you can leave inside of it and take advantage of this tax-free withdrawal because of your standard deduction.
What happens if you have a pension plan? If you’ve got a pension plan, for most people, it’s going to be high enough that it’s going to create not only taxable income, but it’s also going to create an issue with provisional income. If that is the case, you are probably going to want to completely empty out your tax deferred account so that those assets are in a tax free environment, so you’re not increasing the tax that you’re having to pay if you get in that situation.
Another time that you’re going to want to fill this bucket is if you work for an employer where they are offering a match. If they offer a match to where you can put money into the tax deferred bucket, and they will match at 100%, you want to take advantage of that because no matter how high tax rates go, they’re never going to be 100%. You’re getting free money.
Depending on your facts and circumstances and where you’re at in your life, you may then want to do a conversion at some point to get the money back out of that account. But even if you do, you’re still ahead because of the free money that they gave you with the money going in.
The tax deferred bucket can be a great bucket if used correctly. Unfortunately, it’s been overfunded by most people. The great news , though, if you have overfunded this bucket, you have time to make a change, to convert that money into the tax-free bucket before taxes go higher. Taxes are set to go higher on January 1, 2026. Right now, we’ve got over five years that we can start slowly moving that money into the tax-free bucket.
Why do we want to take our time? Because if not, you may end up finding yourself in the highest tax bracket or a higher bracket than you’re normally in because of the conversion because all this conversion money is going to be taxed at the time of the conversion.
Hopefully this gives you a better understanding of the tax deferred bucket. Again, it’s a very critical bucket in your retirement. One of the things that we teach is the importance of multiple streams of tax-free income. If you’ve got a situation where your Social Security is not taxed, because there’s no provisional income beyond the maximum amount, your tax deferred bucket is at the right amount, so you can get money out of there without paying tax. You then have a Roth IRA, a Roth conversion, maybe a Roth 401K, or even a life insurance retirement plan as you start adding these various streams of tax-free income up during your retirement. What you’re going to find is you’re going to be able to extend your money substantially during your retirement years.