With taxes likely going up in the future and a huge baby-boom population going into retirement – the government does expect to cash-in.
And with the passage of so-called SECURE Act 2.0, most non-spouse inheritors of those retirement accounts will be forced to empty them out – at the then current tax rates – within ten years. At that time, they’ll likely be in their highest earning years and already in high tax brackets, maybe being forced into even higher ones.
This probably has you wondering if maxing out your 401(k) is still a smart move. Money matters can be confusing, and the thought of giving more of your hard-earned cash to the government might make you cringe. Let’s break it down to help you decide if going all-in on your 401(k) is still the way to go. I don’t have a crystal ball; but then, financial planning isn’t always about what we know – it’s often about what we don’t know, as well.
Understanding your 401(k)
Let’s start with the basics. A 401(k) is simply an account where you can stash your money for later in life – a time when you’d like work to be an option instead of a requirement. The good news is that you get to contribute to it with your pre-tax income, which means you’re reducing the amount of money the taxman can get his grubby paws on right now. Plus, your employer might even throw in some extra dough to sweeten the deal. Free money! – a good reason right there to max out contributions. So far so good: you stash the cash and don’t pay taxes (yet) on the income that money represents.
Oh, yeah – It Can Grow Too!
The very fact you’re reading this – a financial blog – means you very likely know about the power of time and compound interest. When you max out your 401(k) consistently, you’re giving your money the opportunity to grow like a wild weed. It’s like planting a seed and watching it sprout into a money tree. Even if taxes go up, the compounded growth within your tax-deferred 401(k) account could be juicier than the extra taxes you’ll pay later. Obviously, this may or may not happen, but that employer match sure helps.
But, be sure to remember the definition of tax-deferred: it means tax-delayed. Hmmm. This is where things can get dicey. Note: The IRS has a claim on part of your balance; but, it has a claim on part of your losses, too! See why here.
Evaluating Potential Tax Increases
Then there’s the elephant in the room: higher taxes. As we said at the top, this can be a potential time-bomb for many. Some think, not without good reason, that The SECURE Act is really about making the government more secure.
One thing to keep in mind: tax rates are about as predictable as a soap opera plot. They go up, they go down, they change more often than your favorite pair of socks. Trying to time your retirement savings based on potential tax changes is like trying to predict the next viral cat video—it’s a risky game.
What to do? Focus on the long-term. Your retirement goals shouldn’t be swayed by short-term tax rate wobbles any more than you’d gamble on short-term market moves based on what traders are doing. Dumb, but people do it.
This may be one of the most misunderstood areas of investing. Warren Buffet once said diversification is protection against ignorance. I won’t argue the point, but for most of us mortals there are some things worth diversifying. Risks come in many forms: inflation, tax-law changes, economic conditions, etc.
One of the most misunderstood is market risk. People believe you can reduce market risk through diversification. Think about this: if you purchased every single stock in the stock market (in the name of diversification), would you have diversified away your market risk? Of course not. You would have only replicated the market’s risk. So you can’t diversify away market risk. But, you can minimize business risk! There’s more to learn about diversification. You might like my report, which you can access here.
Then, there’s tax law changes – legislative risk: if you believe taxes will be higher in the future, as discussed at the top, you may want to consider concentrating your stock holdings in regular taxable accounts while keeping your bond holdings in tax-delayed accounts. Bonds are less likely to grow as much as stocks, but the interest isn’t immediately taxed. Stocks in the taxable accounts may pay capital gains taxes, which are generally lower, when they are sold. It sounds counterintuitive; but the math often makes sense.
Now, here’s where people can often fool themselves. As a planner and advisor, I’ve seen it many times: the failure to understand what diversification really means. I’ve seen cases where one person would hold the same investments in five different IRA accounts believing that approach constituted diversification in their eyes.
The fact is an account is like a drawer in a desk. Drawers are simply places to hold things. The drawers simply hold investments. Whether you split an investment into five drawers or only one, the rewards are the same and the risks are the same.
Did you know there are four stages of retirement?
And, did you know that each stage is unique from a tax standpoint? Ready to invest about 45 minutes in some learning? Grab some coffee. You may find this video enlightening.
If you’re in or nearing retirement – or even approaching that age where sound financial decisions have become increasingly important – you may find an introductory call worthwhile. You can learn more here.
Enjoy the video!