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June 17, 2014 at 10:45 AM
Because every client’s needs are unique, a canned approach to tax-efficient savings of Roth IRAs, traditional IRAs, 401(k), 403(b), NQ annuities, NQ accounts, etc., is not necessarily the most flexible or tax efficient option for every client. As advisors, we know that the words “tax-free” don’t always mean there’s no tax ever paid, just like the term “pre-tax” doesn’t mean there’s always more tax to be paid later.
The point I’m making is that tax law changes and client circumstances can change the landscape for what’s the most tax-efficient savings strategies today versus tomorrow. This is my second blog in a series on what I learned (or was reminded of) in the latest tax season; my first blog, Why I Don’t Like Roth IRAs: Tax Season Lesson, Part 1, garnered some praise and criticism from readers. In this blog, I present two current strategies that I believe might help many clients over the next few years.
Strategy 1: Tax Bracket Savings
Based on today’s tax laws, a family making a middle class living whose taxable income falls into the 15% tax bracket after deductions and exemptions is better off paying the 15% tax on their savings, rather than tax deferring it in an IRA or 401(k) for only a 15% benefit. However, if someone is employed by a company with a 401(k) plan offering a company match, they should contribute and take the free money. After saving the needed amount for the match, it may be better for the client to pay the tax and save money elsewhere in after-tax account structures.
So what type of client would this strategy work for?
A married couple filing joint returns with no kids could gross $94,100 while only paying 15% tax on after-tax savings. The 15% tax bracket threshold in 2014 is $73,800 + $12,400 standard deduction + $7,900 personal exemptions = $94,100.
The same family with four kids would be able to gross $109,900 ($73,800 + $12,400 + $23,700) and still fall into the 15% federal tax bracket on their income. This may even be beneficial at the 25% bracket for those who expect to be in the 28% or higher bracket for most of their future earnings periods.
Beyond the 25% bracket, it’s a case-by-case situation, but tax deferral at those stages becomes very beneficial for managing future retirement income, as most clients whose pre-retirement income is beyond the 25% bracket, rarely need income levels in retirement above 25%, assuming all debts are paid off prior to retirement, which builds in an indirect return of pre-tax savings versus post retirement withdraws.
