Protecting retirement assets from rising taxes

President Obama intends to raise income taxes on the rich, and since earned income is the source of most retirement savings, trying to reduce such income taxes is important for retirement plan funding.
Being rich means you’re in at least the top 5% of wage earners. However, given the projected future deficits, the odds are the definition of “rich” may expand somewhat in the future.
But the tax rate clients pay on their and the ultimate savings is often a matter of timing.
As the political and economic winds shift, it’s possible that a period of higher taxes may be followed by a period of lower taxes, and vice versa. This has been the case historically with income tax rates. They have cycled from a low of 7% to as high as about 90%, although during the really high cycles there were far more opportunities for income tax avoidance.
The bottom line with taxes is that they tend to move in cycles. And helping clients plan for the future means using all the tools at our disposal to position them for a range of probable tax outcomes, some higher and some lower.
Planning options
When it comes to earned income, we basically have two tax planning tools: (1) tax deferred accounts and (2) tax-free Roth 401(k)s or individual retirement accounts. Because rates generally change over time, you want to work both sides of the tax equation.
With tax deferred accounts, you avoid current income tax rates, but pay future income tax rates at the time of distribution. Thus, during periods of higher income taxes, you probably want to fund as many tax deferred accounts as possible. With high tax rates, the current deduction is quite valuable, even if rates never decline. And if rates do decline by the time the money is distributed, then you get a nice tax savings.
With tax-free accounts, you pay current income taxes by getting a deduction for the contribution, but avoid all future taxes. Thus, during periods of lower income tax rates, you probably want to fund the Roth. The loss of the current deduction isn’t too costly, and if rates are higher when the money is distributed, you produced a nice tax savings.
Currently, many people believe we are in a relatively low income tax environment and the odds of tax increases for many clients are pretty good. So for clients who are facing a potential rising tax environment, a good strategy is to suggest they take advantage of current lower rates by maximizing any tax-free opportunities.
That means using the tax-free Roth 401(k), if offered, or Roth IRA, if they qualify. Or, consider converting an IRA to a Roth IRA beginning in 2010 when the income limits are removed. In either of these cases, you are basically trying to pay tax at today’s perceived lower rates and avoid future taxes at higher rates.
But at the same time, you should consider the potential that your clients may be subject to lower income tax rates in the future. Again, many periods of rising tax rates were eventually followed by lower rates. Additionally, even if tax rates don’t change, the tax life-cycle for many clients subjects them to higher income taxes while working, but lower taxes once retired as their ordinary income declines.

So, to address a period of higher rates followed by potentially lower rates, you also want to figure out how to fund the tax deferred accounts to a maximum. This allows you to avoid the high rate and potentially pay tax at the lower rate upon distribution.
Basically, you want to work both sides of the tax equation. For clients who own their own businesses, a good basic strategy is to use a Roth 401(k) feature and then make the maximum contribution to a profit sharing plan. That gets you both the tax-free and tax-deferred treatment on earned income.
More sophisticated planning for business owners may incorporate funding defined benefit plans. Depending on the employee demographics of the business, contributions can be surprisingly large for business owners, sometimes two to three times what could be contributed to a profit sharing plan.
Alternatively, if a client has a Roth 401(k) feature at work, but has outside consulting or other earned income, the client can use the Roth 401(k) and then open a tax-deferred simplified employee pension plan for the outside income.
Because tax rates are volatile and subject to change, it makes sense to use every tax-deferred and tax-free vehicle available to build assets for retirement.
If clients have multiple accounts with different tax treatments, then they can lower their effective tax rate by accessing the most favorable accounts during different income tax cycles.

Related Topics: From The Experts, Retirement INsight