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THE THREE-LEGGED stool is a metaphor for how the post-Second World War generation looked at retirement. The legs represented Social Security, an employer pension and personal savings. All three legs were viewed as necessary for a solid retirement plan.
Today, that notion seems quaint. Pension plans continue to be phased out. The number of employees covered by a defined benefit pension has been declining for decades, falling to 26% as of 2019, according to the Bureau of Labor Statistics. And while we can be confident that Social Security won’t disappear entirely, demographics may dictate that benefits become less generous. With two of the three legs damaged or missing, we’re left to fend for ourselves, amassing our own savings to pay for retirement.
Still, I think we might want to revive—and revise—the three-legged-stool metaphor. But now, it’s about tax flexibility, especially the flexibility to manage our tax bill during our retirement years.
The first leg of our new stool represents tax-deferred retirement accounts, such as 401(k)s and traditional IRAs, to which many of us have contributed during our working years. The money in these accounts was contributed out of pretax income—which means it was never taxed—and, ever since, has been allowed to grow tax-deferred. But when these dollars are withdrawn, the tax bill comes due, with taxes owed at ordinary income tax rates. Under current rules, we must start taking those withdrawals at age 72.
The second leg represents after-tax retirement dollars. These are any account with the name Roth attached, including Roth 401(k)s and Roth IRAs. Roth accounts are funded with after-tax dollars and are allowed to grow tax-free. When we withdraw funds, we can do so without paying any taxes on our gains, assuming we follow the rules. Furthermore, we aren’t required to take any withdrawals once we’re retired, which means we can leave these accounts to grow and then bequeath them to our heirs.
The third leg is represented by taxable account money. We’re talking about traditional brokerage and mutual fund accounts that don’t have any special tax privileges. Contributions to and withdrawals from these accounts don’t enjoy any tax benefits. Sold an investment winner? Received a dividend? Uncle Sam will expect a cut when we file our next tax return.
My contention: To create a strong foundation for our future retirement, we want the assets represented by these three legs to be as equal as possible. But don’t worry if they aren’t. Most of us with retirement accounts have far more in tax-deferred savings than in tax-free Roth savings. The idea of tax-deferred savings arose in the 1970s, while the idea behind Roth savings only came about in the 1990s. The expansion of Roth accounts to workplace retirement plans took longer still. The upshot: It’s been a challenge to strengthen that particular leg.
At one time, the standard advice was to max out our tax-deferred savings during our working years. This reduced our current tax bill by reducing our taxable income. It was also expected to reduce our tax bill in retirement, because our taxable income—and hence our tax bracket—was expected to be lower. But this is incomplete advice. Stashing everything in traditional retirement accounts will limit our flexibility once we reach retirement.
The fact is, we have no idea what tax brackets will exist during our retirement years. We experienced changing tax rates and brackets as a result of 2017’s tax law, and we’re on the cusp of raising those rates back up again. If that doesn’t happen in a new tax law, it could potentially happen in 2026, when parts of the 2017 tax law sunset.
Because of this uncertainty, we should make sure we have options in how we pay for our retirement years and in what accounts we leave behind for our heirs. To minimize our tax bill throughout our retirement years, we should strive to have the choice each year to take tax-free withdrawals from a Roth, or generate taxable income with a traditional IRA, or perhaps realize a long-term capital gain in our regular taxable account. Flexibility is crucial—and that’s what we get with the new three-legged stool.
Phil Kernen, CFA, is a portfolio manager and partner with Mitchell Capital, a financial planning and investment management firm in Leawood, Kansas. When he’s not working, Phil enjoys spending time with his family and friends, reading, hiking and riding his bike. You can connect with Phil via LinkedIn. Check out his earlier articles.
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Phil,
I’m curious about your opinion regarding using different asset allocations for each of the three legs. A traditional withdrawal strategy (and the one I’m using) is to use the taxable account first, then IRAs, then Roths. Depending on the relative amounts in each type of account, this strategy can provide very different investing time horizons for each of them.
In my case, I’ll start using the IRA funds in about 6-7 years, and I won’t start to use the Roths for about 18-20 years. Because of that, my stock/bond allocation is 50/50 in the IRAs, but 75/25 in the Roths. (Of course, the allocation in the taxable account is tougher to adjust if one is trying to minimize taxes (and income for ACA purposes) in the years before qualifying for Medicare.) In my mind, the overall asset allocation (which is what we all read about) is less important. (I don’t think I’ve ever seen an article about asset allocation by account type/time horizon.)
Does this make sense to you? Thanks.
Phil,
Thanks for a thought provoking (and comment provoking article). My wife and I are working through many of the issues brought out by the commneters. One of my questions is how to judge the success of a particular strategy. Is it minimum life time taxes paid, maximum lifetime income, maximum yearly income, or maximizing inheritance. Obviously this is very personal, and would be much easier if we could read the future.
Rick, this may sound simplistic, but you won’t know the results until your time is up. The main thrust of the article was gaining the flexibility to draw income from wherever it suits you best. The once strongly held idea that taxes will always be less for you in retirement is history. I have no idea what tax levels will be when I’m retired, let alone what tax bracket I’ll be in. Phil