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Has this question ever crossed your mind? If not, it should. Too often, folks just move to the automatic answer to this question; they tell me, “I save in my employer’s 401(k)” or similar plan. “If deposits can come from my paycheck, so much the better”; is a response I hear a lot as well. This answer is much better than not saving at all, but the question is whether this is the best way to save for retirement.
If this is true for you, then ask yourself a few questions:
- Do I understand the investments I am using and am I happy with the choices available to me?
- How much am I currently paying in taxes?
- What do I think tax rates will be when I go to spend the money?
- Do I have a plan in place to manage taxes when I retire?
- Will I have enough when it is time to retire?
Let’s take a look at each topic:
-I find that most folks don’t know what is inside the fund choices they make in their employer’s plan. That is why, according to many surveys, the majority of invested assets in 401k’s are in “Target Date Funds” These are funds that are made up of a mixture of other funds created by that fund family. In theory, these funds will reduce the amount of money in riskier funds as you approach retirement. Unfortunately, these tend to cost more and produce less. I looked at a client’s Target 2045 fund recently. They were paying a .79% management fee, plus a .3% 12b-1 charge. This isn’t bad, except now you have to add in the cost of the funds it holds. One of the largest holdings had a 1.54% management fee, plus the .3% 12b-1. That means if that is an average cost, the owner is paying nearly 3% in fees, plus the additional non reported costs in those funds. Costs are one thing we can control; make sure you are getting value for those fees! There are a lot of choices in this world, make sure you are comfortable with your investments.
-Do you know what your tax rate is? There are 2 numbers you should know, your effective rate, which is the percentage of your gross earnings that you will pay, and your marginal rate, which is your tax bracket and the amount you will pay on the next dollar you earn. If there is a big difference in these numbers, it means that you are using tax deductions to offset what you are paying today. The main deductions available to most of us are business expenses, your kids, and your mortgage. For most folks, they won’t have those deductions available to them once they retire and start to draw those funds. This could lead to a big increase in the taxes you pay once retired.
– What will taxes be when I retire? It is impossible to know. What I do know is they will be different, congress can’t stop making changes. When I ask groups if they think rates will be lower in the future, over 90% tell me no. As we just discussed, most people lose their deductions in retirement, so even if rates stay the same, most will be in a higher effective tax rate when they retire. That can defeat the purpose of “deferring taxes to a time I will be paying less”.
– Do I have a plan in place to manage taxes once I retire? Since we don’t know what taxes will be in the future, I usually encourage clients to diversify their exposure to the tax code. Just like most people don’t trust their portfolio to a single stock or fund, for the same reason, you don’t want to be exposed to only one part of the tax code. Retirement plan withdrawals are taxed as “ordinary income” just like your wages. Some other areas of the tax code are capital gains and my favorite; tax free. In addition, certain asset classes enjoy favorable tax treatment. Real Estate, Oil and Gas, and Life insurance are some examples of assets that can provide tax relief and tax diversification.
– Will I have enough when I retire? The key here is remembering, it isn’t how much you have, but how much you can spend out of what you have. Too many are asset rich and income poor when they retire. This means they will have the burdens and risks of wealth without the ability to fully enjoy the advantages that wealth can bring. At Gainer Financial, we have always helped clients accumulate wealth using strategies that will provide clients with the most net spendable income possible in retirement. If you have questions or are curious as to how this can be accomplished, contact us and we can discuss your personal situation.
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