Tax planning for clients during tax season always generates new strategies and ideas, as unique situations tend to get my analytical wheels turning. From a risk/reward wealth management perspective, I like to look at tax planning with the actual cost to the client in mind, including what is the best cash flow option, because the most tax efficient savings strategy for each person’s situation is the ultimate wealth planning strategy. Here are a few thoughts that may also relate to your clients:
Negative Cash Flow Savings
I’ve never been a big proponent of the Roth IRA due to its drastic current negative cash flow. Here’s what I mean by negative cash flow savings: Let’s assume your client can put $6,000 in a Roth IRA, which costs them $7,800 in cash flow to save $6,000 (assuming a 25% federal and 5% state income tax bracket). Putting that same $6,000 in an IRA will only cost $4,200 in cash flow to save $6,000 - assuming the same tax rates above.
I’ve learned that most clients want to save money for retirement, while also living a little along the way, traveling and enjoying quality time with kids/family as they age. The IRA savings example above gives families an extra $3,600 of cash flow per year, which they could further save or spend. Of course, many of you will argue that the Roth IRA is tax-free for life, while the other is taxable when withdrawn. That’s true, based on the current tax laws. However, in my experience many clients live on less money in retirement, usually dropping them at least one tax bracket below where they saved/contributed the money while working.
For example: Assuming the same tax rates above (25% federal and 5% state – for a total of 30%) for a client contributing to an IRA, in most cases, that client withdraws money out of an IRA during retirement at a total 15% bracket (15% federal with little or no state income tax on retirement assets, depending on the state of residency). This example provides long-term tax-free savings comparable to a Roth IRA when also considering the overall total cost of the long-term differing cash flow effects mentioned earlier. For further clarification on this point, you may want to read a past article of mine entitled: The Gamble of a Lifetime.
Income Qualifying Limits & Low Contribution Limits
The second reason I’m not a fan is the Roth IRA’s low income qualifying restrictions and the IRA’s low contribution limits. If an investor is not part of a 401(k) or covered pension plan where they work, the odds are pretty much stacked against them for retirement savings. In 2014, Roth IRA income limits for single filers are $114,000 to $129,000, and for joint filers it’s $181,000 to $191,000, with both IRA & Roth IRA contribution limits maxed out at $5,500 each unless over age 50.
Therefore, if we still assume a 25% federal and 5% state tax bracket, plus a prudent low-end savings of 15% of income per year to fund a client's retirement, let's further assume a single filer could actually invest $11,000 between both an IRA ($5,500) and a Roth IRA ($5,500) in retirement-specific accounts each year (current IRS rules only allow $5,500 maximum in a IRA or Roth).
As such, a single filer would already be short $6,100 (15% of $114,000 - $11,000) in retirement savings, if it were possible to effectively contribute to both an IRA and Roth IRA. If you compare the actual cash flow cost to saving 15% annually, it would roughly cost the non-401(k) covered single filer $18,930 (130% of $11,600 + 70% of $5,500) to save 15% of their $114,000 income or $17,100.
(Note: The above two paragraphs have been modified from the original content to correct a mistake.-Ed.)
A covered 401(k) plan employee has contribution limits of up to $17,500, not including company matching contributions. The same single filer saving $17,100 in a 401(k) plan would have cash flow costs of only $11,970 (70% of $17,100) to save 15% of the $114,000 income or $17,100. The earlier contribution limits indirectly force a huge cash flow difference of $6,960 per year between the two examples. Joint filers are no different in like-kind comparisons, prompting the need to help clients decide where, how much and what works best to tax efficiently save 15% to 25% of income annually for retirement, and enjoy life along the way.
Despite the fact that most clients want to save money, very few can tax efficiently save for retirement while optimizing their current lifestyle. They either save a lot, thereby significantly sacrificing their family’s ability to enjoy life along the way, or save too little, enabling them to experience more with their families, but leaving them on the job till 67 or 70 because they haven’t saved enough. Helping clients tax efficiently save for retirement is a must in our current tax-structured system, so hopefully these ideas provide discussion opportunities with your clients. Look for my next article in the series where I’ll discuss a few additional ideas.