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Jan26, 2023

Tax Diversification

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In this episode of the Great Retirement Debate, Ed and Jeffrey go into detail on Tax Diversification and whether or not that should be something you strive for in retirement.

Episode Transcript

[00:00:00] INTRO: Hi, I’m Ed Slott and I’m Jeff Levine. And we’re two guys who just love to talk about retirement and taxes. Look, our mission is simple to educate you the saver so that you can make better decisions because better decisions on the whole lead to better outcomes. And here’s how we’re going to do that each week. Jeff and I will debate the pros and the cons of a particular retirement strategy or topic with the goal of helping you keep more of your hard earned money. Yeah, but we won’t know which side of the debate we’re taking until we flip a. Winner of the coin flip gets to pick which side of the debate they want to argue. And both of us will have to argue in favor of our respective positions, whether we agree with them or not. At the end of each debate, there’s going to be one clear winner. You a more informed saver who can hopefully apply the merits of each side of the debate to your own personal situation, to decide what’s best for you and your family. So here we go. Welcome to the great retirement debate.[00:01:00]

[00:01:02] Ed Slott: Well, welcome back to the great retirement debate. How you doing Jeff?

[00:01:06] Jeff Levine: I’m good. I’m good. How are you today, Ed?

[00:01:08] Ed Slott: Okay, what do we got on the schedule today?

[00:01:11] Jeff Levine: Well, today we’re gonna debate whether an individual should intentionally shoot for tax diversification. In other words, should someone try to always make sure that they have some money in a taxable account, like a individual account or a brokerage account or a revocable trust account. Should someone make sure that they always have money in some sort of tax divert that deferred account? Like a traditional IRA or a 401k, a 4 0 3 B and should someone also make sure that they have some money in tax free accounts, such as a Roth IRA or a Roth 401k. So do we intentionally shoot for having some of those in each basket, so to speak?

[00:01:57] Ed Slott: Right. Well, that’s a tough debate [00:02:00] because, I don’t know why, because

[00:02:02] Jeff Levine: Well, no one knows what the future holds, right? Yeah. That, that could be one of the most challenging elements, but we’ve gotta pick sides here, Ed. All right. So, uh, you wanna flip a coin today?

[00:02:10] Ed Slott: All right. Uh, uh, what do I do with my, uh, here’s my coin. All right. Uh, what do you, what do you have?

[00:02:16] Jeff Levine: I’ll take tails.

[00:02:19] Ed Slott: It’s tails. You win. What side of the argument? Uh, the debate. Not an argument because it could either one could be good for the right person.

[00:02:27] Jeff Levine: That’s right. Well, I’ll, I’ll argue today in favor of no intentional tax diversification. You could take the argument that people should make sure that they have tax diversification.

[00:02:38] Ed Slott: Oh, good. You always give me the easy argument.

[00:02:40] Jeff Levine: I actually think I have the easier one here. So may, maybe we actually have a true disagreement Ed

[00:02:44] Ed Slott: oh, okay.

[00:02:45] Jeff Levine: All right. This is, this is good. All right. Well, if, if you really feel that passionately about tax diversification, take it away. You, you, you can tell me.

[00:02:54] Ed Slott: Well, in investments, people always say, don’t put all your eggs in one basket, you know, or watch [00:03:00] that basket it’s. But people don’t think about that when they put their money away in their retirement accounts. Yet many people have most of their money in an IRA, a 401k tax deferred account, and they keep loading it up. So if you’re just looking at your retirement accounts, they’re loaded up all in one big giant bag of tax. It’s tax deferred, but that means that money will have to come out. It’s a sitting duck for future higher tax rates. And I think you need some diversification either outside of the IRA completely, for example, in a taxable brokerage account or in a tax free Roth account. But I wouldn’t have everybody load up everything in a taxable account.

[00:03:43] Jeff Levine: Well, I, I think those are all really good points and I don’t disagree with you that there’s a lot of risk in having everything in a taxable account, not knowing what the future will be, not knowing what future tax rates will look like. Especially for those who have been diligent savers, and great investors their whole lives. Oftentimes [00:04:00] they end up with more income in retirement than they did while they were working, which is a, a wonderful quote on quote problem to be dealing with. But where I really have a knit to pick, Ed, is with the analogy you started off with. And it’s the same analogy I always hear from financial advisors. And even from consumers, who’ve done some research into, uh, this, this notion of tax diversification. They say, well, everyone’s familiar with the benefits of investment diversification and just like investment diversification, you should have tax diversification. Well, to me, that argument doesn’t hold water. And the reason why, is because on the investment side, the reason we diversify is to create a better outcome. Having a more diversified portfolio is the means, but the ends is a better risk adjusted return, right? To get more return for the same level of risk, or to get the same [00:05:00] return as you would with another portfolio, but with lower risk and introducing different things, the diversification of a portfolio, provides that benefit by contrast, when we’re talking about, you know, taxes, what’s, Ed, what’s the number one rule for tax planning?

[00:05:17] Ed Slott: Always pay taxes at the lowest rates.

[00:05:20] Jeff Levine: That’s it always pay taxes at the lowest…

[00:05:22] Ed Slott: That’s my always rule. It’s always been my always rule. Buy low and sell high buying the tax rate. Yeah. I look at the tax rate, like a stock buy low and sell high.

[00:05:32] Jeff Levine: I completely agree with that. I know I’m supposed to disagree, but that’s not our topic for today. Yeah. Okay. So I can agree with that. So I agree on hundred, 100% with you that when it comes to taxes, the number one rule is to pay taxes when your rate’s the lowest. Now let’s imagine Ed that you are a high income executive at a company. You’re fortunate enough to be making, you know, five, six, $700,000 a year. And you are in the 37% bracket [00:06:00] right now. And when you retire, you’re looking at a good amount of income. You’re looking at having $200,000. Let’s say of income a year. Right now you’re married. Maybe that puts you in the 24% bracket. And while we don’t know exactly what rates will be in the future. I would say it’s highly unlikely that we’re gonna go from 24% for someone making $200,000 to 37%. Right. That’s a dramatic shift for someone who is kind of in this. I don’t wanna call it middle income cause $200,000 a lot of money, but effectively

[00:06:34] Ed Slott: Especially in retirement!

[00:06:35] Jeff Levine: Right? Exactly. But, but we don’t distinguish that in our tax code. Right. We don’t penalize people for being in retirement. And, and so with that, with that thought process,

[00:06:44] Ed Slott: Actually we do, they’re called RMDs.

[00:06:46] Jeff Levine: All right. All right, you got me there, but we don’t have different tax brackets for those in retirement. And so if you’ve got $200,000 a year of income, the chances of you paying a 37% rate down the road on that income is [00:07:00] really small. And so if we both agree that the number one rule for tax planning is paid taxes at the lowest rates. The entire time that individual is working, they should be deferring into a traditional 401k or 4 0 3 B and then, and only then when they retire, maybe we look at Roth conversions, but that means maybe if this person comes into the office, my office, when they’re 35 and they’re planning to retire at 65 for the next 30 years, I’m planning on zero tax diversification for them. I’m going to have them plow everything possible into a tax deferred account because following our number one rule of tax planning, the lowest rate will be in the future.

[00:07:45] Ed Slott: Well, that could be, but probably not. That’s that ties in to the big myth that I call it. People always tell me, especially retirees or people contemplating, uh, where to keep their money tax deferred or tax free. Should I keep plowing into an [00:08:00] IRA or 401k? And they said, well, I’ll always, I’ll be in a lower bracket in retirement and that just doesn’t hold up. As you actually said, I I’ve had clients come to me over the years in retirement doing their taxes. They said, Ed, how could it be? I mean, I mean, I have more income than my best years working. Well, that’s because you load it up in IRAs, like you just said, or 401ks and tax deferred. And now all of those funds have accumulated and grown and compounded. And now your RMDs, your required minimum distributions have turned out because you were such a good saver over a long period of time that your, your forced distributions, your RMDs are higher than your income was. Plus you likely don’t have the deductions you did while you were earning that money. You probably don’t have a mortgage, but a lot of the deductions are gone, no deductions for children and things like that. So you may be in a much higher bracket when you’ll need the money the most, in [00:09:00] retirement, when the paycheck stopped, there’s generally not no money coming in. So that money has to last longer. I’d rather have more of that money funneled say into a Roth IRA. In fact, I would even take your argument where, to have no diversification, but the other way, have everything in a Roth growing tax free for the rest of your life and beyond, you never have to worry about what the uncertainty of future higher taxes could do to your standard of living in retirement. If you believe like me, that even when you say rates might not go up, but I don’t think they’re gonna go down, especially for somebody who’s been a high earner. That’s a question I get a lot too. Uh, people say, well, if I’m a high earner, shouldn’t I be taking the deductions now, like in the 401k and putting it in the IRA. Because I’m at my, you know, high bracket and that’s another rule of tax planning. Obviously you want deductions when rates are high and you want the income when when rates are lower. Uh, [00:10:00] but, uh, it may not come out that way. It may come out that your personal rates, who knows what the rates will be in the future. And that’s that uncertainty. But I find people who do well throughout their lives and earnings, like the person you talked about in your example, are, are generally always gonna be at the top bracket, even in retirement.

[00:10:20] Jeff Levine: Yeah, I’ve heard, I’ve heard it said before that our tax system is a penalty on savings.

[00:10:24] Ed Slott: Oh yeah. Yeah. I’ve said that.

[00:10:26] Jeff Levine: I don’t remember where I heard that, but some, some guy once, uh, some guy once said that.

[00:10:31] Ed Slott: It’s a penalty on savers. So that’s my point. The more you put away, uh, the more likely any future higher rates are going to hit you the hardest.

[00:10:41] Jeff Levine: Well, I, I think there, there are two things I’d unpack there. First off with reasonable projections. We can say roughly what someone’s income will be later in life and, and, and what it is today. And so if we had someone who we were projecting might be in the, you know, let’s, let’s imagine that [00:11:00] higher earner I was talking about before. Let’s say they were looking at 37% today and all things being equal we thought they might be at 35% in the future there, the difference of 2%, I could kind of buy your argument of saying, well, we don’t really know, like 35%. Like you could see that increasing three, four, 5%. Maybe rates will be higher in the future. But oftentimes I see individuals where their retirement income or their, their future years income will be so much substantially lower than what they’re making today, that it would take wild swings and tax rates to, to make those, uh, conversions profitable. And I also see it the other way sometimes. So you mentioned potentially all in a Roth, you know, another area where tax diversification, I don’t think makes a lot of sense is. You know Ed, I know you’re a super big believer in the Roth IRA for young people, especially, uh, because you’ve got the longest time to compound, you have, uh, tax, you know, you have, uh, you have low income relative to your future years. At least one would hope so, you know that you’re gonna continue to grow in your [00:12:00] career. You have a small balance. If you’ve got money in a pre-tax account, uh, you know, it’s inexpensive if you wanted to convert it to a Roth IRA, cause it’s just smaller balance than you hopefully will have when you’re, you know, closer to retirement. So for all those reasons, I know you’re a big believer in the Roth for young people. Imagine someone who makes let’s give a, a great example, Ed. Let’s say a young person who’s working as a, a 16 year old has a great summer job, and they make $6,000 for the year. They pay $0 of income tax on that $6,000 because they’re below the standard deduction and that’s their only income for the year. Well, you could take some of that money and put it in a traditional IRA, but the deduction is not worth anything if they don’t get a deduct…

[00:12:43] Ed Slott: You wanna take deductions when rates are high.

[00:12:46] Jeff Levine: That’s it. So once again, that’s another example where I would say the goal of tax diversification is not the goal, like the goal of tax diversification. When someone says, Hey, you should have some Roth or, you [00:13:00] know, you should really have some traditional IRA or whatever that may be because you don’t have any yet, that is not like that is to me, the myth that too many people fall into, because what we’re both really agreeing with here at, at the heart of this is try to pay tax when your rate says lowest. And if you’re that young person, you don’t want tax diversification, you want it all in the Roth because clearly your rate is the lowest then because it’s zero and just like that..

[00:13:27] Ed Slott: Let me go, let me go to your other argument.

[00:13:30] Jeff Levine: Okay. Go to my other argument

[00:13:31] Ed Slott: The arguement about you want outcomes. And the reason I like the Roth, even for people who are older is because the last thing, and this is just maybe a personality thing. Nobody wants to pay more tax when they’re in retirement, because there’s not new money coming in. So everything coming out, I know people who are have the Roth, they love it. There’s no RMDs for the rest of their life. They’re not forced to take distributions. They never have to worry. And the money’s just growing tax free and it’s off [00:14:00] the table. So that may be a behavioral thing, but people love the idea of being free from taxes once they’re in.

[00:14:08] Jeff Levine: Well, there is something to be said for that. And ultimately if it’s your money and you feel good about it, it’s truly all that matters. Right? I mean you, if, if you are more concerned about overpaying taxes than you are about quote unquote, feeling good, then pay lower taxes.

[00:14:23] Ed Slott: Well, I’m using the the outcome argument you have, you know, it depends what you want is your outcome. If you are in retirement and you can have zero taxes, you’re not that worried that’s your outcome. As you said, you’re not that worried that well, you paid for that all those years, you’re working, but now you’re here and everything’s tax free forever.

[00:14:41] Jeff Levine: The math nerded me just says, if you’ve overpaid to get there, then that probably wasn’t the most effective way that maybe you could have gotten there over time in a slower way. You know, one you know, if you go to the extreme,

[00:14:54] Ed Slott: oh, so that’s an argument for more diversification.

[00:14:58] Jeff Levine: Well, it’s simply a matter of, I don’t [00:15:00] know, but always try to pay tax when you think your rate is the lowest, if that results in tax diversification, I’m okay with it, right? It, the I’m not anti-tax diversification. I’m anti you should go, like that should be your, your, your aim. When you create a portfolio, going back to that analogy, you aim to create a portfolio that is diversified or diversified rather with taxes I aim to pay tax at the lowest rate. And if that results in tax diversification for me. Awesome. If that results in me having all money in a traditional IRA or all money in a Roth. Awesome. If I think I’ve paid tax at the lowest rate, I’ll throw one more out where I think agree at it.

[00:15:40] Ed Slott: You put in the word, think the problem is the uncertainty of what future higher tax rates will be.

[00:15:47] Jeff Levine: That we, that we once again agree on I’ll and I’ll throw one other that we, that we agree on, uh, or at least I think we agree on is that if you have the opportunity to put money into a retirement account, either a traditional or a Roth [00:16:00] style, it would generally, and, and again, always, maybe some edge cases, but it would rarely make sense to put money in, let’s say a taxable account, before you would put money into a retirement account, because either you like the deduction and you go to the traditional or you think you don’t need the deduction, but you go to a Roth instead. The only time I’m just thinking out loud here, Ed, the only time I could see avoiding a let’s say a Roth 401k where you had that option is if you knew you needed the money relatively soon, but you’d still be working, so you wouldn’t have access to the money in the 4 0 1, the Roth style 401k. But otherwise, when the money goes in, there’s no tax difference the Roth 401k and a taxable account. So why would you not put your money in a tax free growth account, if the cost of getting there is the same as an account where everything in the future is taxable.

[00:16:49] Ed Slott: Right. Well, the Roth to me I’m, as you said, I’m a big Roth fan because I like that outcome never having a worry about future higher tax rates, but I still think the taxable [00:17:00] brokerage account, you know, outside of an IRA has its own advantages. You know, it has to step up in basis. If you hold it to a death, you have capital gain rates. So it’s kind of in the middle between Roth and a taxable I and a tax deferred IRA.

[00:17:14] Jeff Levine: All right. Fair. You know, and I think we’ll leave it there for today, but two really good sides here. I think, uh, amongst the strongest arguments on the tax diversification side, I think is the argument, we just don’t know what future tax rates will be.

[00:17:31] Ed Slott: That’s it.

[00:17:32] Jeff Levine: So even if you say, Hey, it’s unlikely that tax rates will go up. This. How do you know, maybe we will really, maybe somebody making $200,000 a year in 10 years, will be paying a 35 or 40% tax rate because we’re gonna need it to support things like social security and to finance everything else we’ve agreed to and whatnot. I think the stronger argument on the don’t aim for tax diversification side is that tax diversification and [00:18:00] investment diversification don’t equal one another. They are dramatically different things. One is a benefit that like having diversification of an investment portfolio creates inherently a benefit, whereas tax diversification to me of a, uh, tax diversification, that is, is the outcome of doing the good planning beforehand, which is always trying to pay tax when your rate is the lowest. And even though you may not know that for sure. Maybe you could take some pretty good educations over time, educated guesses over time. You agree?

[00:18:32] Ed Slott: Well, I think we’re, partly, I think they both come out, uh, the outcomes, but the outcomes are different.

[00:18:40] Jeff Levine: All right. Fair enough. Well, Ed, there are two sides to every coin, right? Uh, but of course, when you’re listening today, your life and your retirement is too important to leave up to a coin flip. And that’s why one thing I know Ed and I always agree on is making sure you’re talking through any big decision with a knowledgeable financial [00:19:00] advisor or tax professionals so that you can weigh the pros and the cons of different options against your specific set of goals and objectives. If you’d like to continue the discussion with Ed and I we’d love to hear from you, uh, tell us what points you think were great. Tell us what points you didn’t like. Tell us if we missed something, tell us if you’ve got an idea for a future topic, you can reach out to Ed on Twitter @TheSlottReport. That’s @TheSlottReport T’s report. You can reach out to me at @CPAPlanner. Again, that’s @CPAPlanner. We look forward to hearing from you real soon, Ed, this one in particular was fun.

[00:19:34] Ed Slott: Good outcome.

[00:19:36] Jeff Levine: All right. I like it. We’ll leave it there. We’ll see you next time on the great retirement debate.

[00:19:42] OUTRO: Jeffrey Levine is chief planning officer for Buckingham wealth partners. This podcast is for informational and educational purposes only, and should not be construed as specific investment accounting, legal or tax advice. Certain information mentioned may be based on third party information, which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but it’s [00:20:00] accuracy and completeness cannot be guaranteed. The topic discussed in corresponding arguments are those of the speakers and may not accurately reflect those of Buckingham wealth partners.