How To Think About Tax Advice
If you look at social media, you have a bunch of money coaches who say the Roth is the best thing you can invest into. Whenever you hear all or nothing advice, you should question if that advice is the best thing for you. It could be good for you, but is it the best thing for you?
It all depends on your situation and your goals, which should determine what you should do with many things in life. With it comes to investing in tax advantage accounts, there are two options tax-deferred and tax-free. The tax-free label is misleading because these accounts use contributions that have already been taxed. Then the money grows tax-free. While a tax-deferred account will receive a tax break now and then gets taxed with the money is withdrawn.
Let The Numbers Help You Decide What's Best
In 2022 someone can fund an employer-sponsored plan like a 401k at $20,500, and an Individual Retirement Account (IRA) can be funded at $6000. If someone decides to fund this account(most of the time, they should), they need to determine whether they want to make tax-deferred or tax-free contributions. If a single person is making $100k per year and saves the entire $20,500 into their 401k, it is not as simple as just saying they funded their account at $20,500, since the person needs to look at their tax situation today versus when they plan to withdraw the money.
A $100k salary and filing taxes as a single person are most likely going to cause them to take the standard deduction in 2022 of $12,950. This deduction would drop their marginal tax rate from the 24% tax bracket to the 22% tax bracket.
So if they invest $20,500 into a traditional 401k, they would save 22% in taxes in 2022 and whatever their state tax rate is, but in this example, we’ll say 5%. The person would still pay social security and medicare tax on their full salary, so this doesn’t have to be considered. So the total tax savings for 2022 would be 27%.
If someone decides to invest in the Roth option, they would have to fund the account with after-taxed dollars. So the amount required is $28,082.19 since 73% of this amount would be $20,500. This Roth contribution would cause the person to spend an extra $7,581.19 in taxes in 2022, while the person doing the tax-deferred account would save this amount in taxes for 2022. Someone might benefit from having that extra $7,581.19 today and could benefit from lowering their Modified Adjusted Income so they could deduct student loan interest. Still, it all depends on someone’s situation.
When it comes to funding both accounts, under the right circumstances, there is no monetary advantage. A person who saves $20,500 of their income and funds a traditional account can invest the full amount, while the person doing the Roth can invest $14,965 because the effective 27% tax rate has to be applied. And if we look over 35 years, we can see they are the same
*Assuming an 8% rate of return
- Tax-Deferred – $20,500 in 35 years is $303,099.56
- Tax-Free – $14,965 in 35 years is $221,262.68
With the $303,099.56, if someone is going to be in the same tax rate of 27%, then the purchasing power of the $303,099.56 is $221,262.68 because of the tax. So as long as someone is going to be in the same tax bracket, it depends on when someone would want and need the tax break, either on the contribution or the withdrawal.
Understand How Your Situation Is Dynamic and Not Static
Other things to consider are the tax bracket they will be in when they contribute and withdraw. If someone will be in the 35% tax bracket in 2022 but will drop to 12% in 2060, it probably makes more sense to do the traditional. And vice versa with the Roth, if someone is going to be in a lower tax bracket today, and a higher one in the future, then it makes more sense to do the Roth in most cases.
Overall, the better strategy is to have both accounts and fund them based on someone’s income situation for the year. Here is an excellent chart from Kitces.com that shows an example of how someone should fund a traditional or Roth account.
Whatever someone does, they should know what will give them the most options now and in the future and understand the tradeoffs for making one decision over the other. But doing this type of analysis requires knowing your goals, your income capabilities this year, and the current and future tax situation, maximizing your opportunities.
Here is another chart from Kitces.com that shows the benefit of optimizing both accounts based on someone’s unique situation every year.
What It Takes To Know The Deal
Going back to my favorite saying by Warren Buffett, “You should know the deal before you accept the deal.” To get the best deal from tax planning, you have to understand taxes in these three areas.
- Field
- Domain
- Skills
The field for tax planning is congress and them writing tax code, and how these tax laws can be interpreted now and in the future. Understanding how different parties want to tax income can help someone understand how to invest their money based on the government sentiment of the times.
The domain is all the different investment accounts and the individual securities that go into tax planning. Back when I sold financial products, there were some Long-Term Care products that could save people a lot of money in taxes and income that are not around anymore.
Then comes the skills, which are someone’s income, capabilities, human capital potential, and the tax planning professionals’ skills. Once you understand these three cornerstones of tax planning, it can help optimize your accounts so that you get to keep more of what you earn.
Now, I don’t get into the why of tax planning. I try to understand the how and the what of the tax planning because the why is out of my control. If society thinks that taxes should be a certain way, I’ll play by the rules and give advice that is in the best interest of my clients to help them live a fulfilling life that offers them upside potential and minimize their downside risks. But overall, the message is we all play by the same tax rules, and it’s up to us to take advantage of them, or else they can take advantage of us.
An Example Of Knowing The Deal With Tax Planning
A great example of people not understanding tax rules is not understanding required minimum distributions. When someone reaches the age of 72, if they have any tax-deferred accounts, the person is required to take out a certain amount of money from these accounts every year, and the amount that has to be withdrawn gets bigger every year because the divisor gets smaller.
By the time someone reaches 115, they are required to withdraw about 50% of their account values, and at 72, it’s about 3.9% of the account value. RMDs can put someone into a higher tax bracket into the future that they will have to pay taxes on. Things could change, but right now, this is how the tax laws are written and requires knowing who the players in the field of tax legislation are, the accounts and securities that people can invest in, and how to file their taxes.
The US tax code is very complicated, but someone can maximize their situation with the right strategy. So if you hear tax advice or any advice for that matter, ask what the other things you need to know when it comes to the field and domain are, and what are the skills to use that advice.
After studying the field and advice, you might find out that a person’s skill in giving advice is outdated and shouldn’t be followed. Or you can be confident that the advice is what you should follow, and it will help increase your chances of success in reaching your financial and life goals.
Keeping The End In Mind To Live Your Best Life
Overall in life, it tends to be a better strategy to focus on avoiding bad decisions than concentrating on trying to make great decisions because it just takes one wrong decision to ruin years of planning and execution.
So if you’re looking at the charts above, you don’t have to make every decision right. It’s avoiding the bad mistakes that could wipe out those gains, like marrying someone that is not a good fit for you and ends up in a big legal battle that causes someone to give up half of their accounts in the divorce. So don’t spend all your time learning tax planning if it means it will cause you to neglect your spouse and create a painful situation. Life is multi-faceted and should be focused on a perfect economy.
Don’t do too much, but don’t too little.
There is not enough time in the day to do everything, so choose the activities that will give you the best return on life. It won’t be perfect, but avoiding bad mistakes can make many perfect memories.
Hopefully, now you have more resources to help you design your best life and ask the questions to help you get there. And remember, if you hear the words “Always” or “Never,” realize that they are meaningless words and should look into the field, domain, and required skills to see what advice should be taken.
Please do your own research or contact a professional before you make any changes to your financial plan. This advice is subject to change.
