There is a grim mathematical reality facing Americans who save for retirement in tax-deferred vehicles, such as 401(k)s or IRAs: it is impossible for our government to liquidate $17 trillion of debt (and growing) without dramatically raising tax rates.1 Former U.S. Comptroller General David Walker has even suggested that tax rates have to double in order to keep our country solvent.2
Given the threat of higher taxes, many mainstream financial gurus have begun to adopt “tax-free paradigms” in an effort to insulate their adherents’ retirement accounts from the impact of rising taxes. But what strategies are these gurus advocating, and are all tax-free paradigms created equal?
The best way to insulate your clients from the impact of higher taxes is to put them in the zero percent tax bracket. After all, if tax rates double, isn’t two times zero still zero?
Getting to the zero percent tax bracket involves accumulating precisely the right amounts of dollars in each of the three basic types of accounts or buckets: taxable, tax-deferred and tax-free. When our clients contribute dollars to the first two buckets in a willy-nilly or haphazard way, they unwittingly prevent themselves from ever getting to the zero percent tax bracket. The tax-free paradigm, by definition, advocates strategies that remove the IRS from the retirement equation.
Now that I’ve defined the tax-free paradigm, let’s see how some of the mainstream financial gurus measure up. For starters, there are three basic strategies upon which these “experts” tend to agree:
Strategy #1: Have about six months’ worth of income in an emergency fund (taxable account) to safeguard against unexpected emergencies.
Strategy #2: Contribute to the 401(k) (tax-deferred account) up to the match, but not a penny above and beyond. Do enough to get the free money, then move on!
Strategy #3: Finally, direct any dollars above the 401(k) match to the tax-free Roth IRA.
Pretty standard stuff. There isn’t a mainstream guru out there (Dave Ramsey, Suze Orman, Clark Howard, etc.) who doesn’t advocate these strategies.
But are these three recommendations alone enough to get our clients to the zero percent tax bracket? In some cases yes, but in many cases no.
If you want to understand the make-up of any guru’s (or financial advisor’s) tax-free paradigm, you can apply a fairly easy litmus test. Simply find out what they recommend be done with any surplus savings once Strategy #3 has been satisfied.
Why the “experts” are wrong
To test my hypothesis, I ventured onto the website of leading financial guru Dave Ramsey. Under Ramsey’s general investment philosophy link, I found advice on how to invest any extra savings once the 401(k) match and Roth IRA have been maxed out:
“If your employer matches your contributions to your 401(k), 403(b), TSP, then invest up to the match. Next, fully fund a Roth IRA for you (and your spouse, if married). If that still doesn’t total 15 percent of your income, come back to the 401(k), 403(b) or TSP.”3
So, what should we make of Ramsey’s “tax-free paradigm”? Well, he starts off by adhering to the traditional recommendations, but once the 401(k) match is met and the Roth IRA fully funded, he reverts right back to the 401(k). By doing so, he unleashes a litany of unintended consequences for his unsuspecting adherents.