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Three Other Legs

Phil Kernen

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 But when these dollars are withdrawn, the tax bill comes due, with taxes owed at ordinary income tax rates.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.

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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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Jay Burdman
Jay Burdman
4 months ago

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.

Rick Connor
Rick Connor
5 months ago

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.

Phil Kernen
Phil Kernen
4 months ago
Reply to  Rick Connor

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

Matt *
Matt *
5 months ago

re three legs… its important to consider state taxes. I originally was unhappy about how NJ taxed 401k retirement income. but with the personal exemptions and the $6000 veterans exemption I am now in a tax bracket that allows me to take advantage of the $100,000 retirement exemption. By maxing out my SS benefit which is not taxed by the state I pay no state tax

Roboticus Aquarius
Roboticus Aquarius
5 months ago

Most people should simply invest in Traditional 401k’s / IRAs at least to matching, and (hopefully) max them out if the fees and funds are reasonable. Roth and Post-Tax investing are situational options. Long comment below.

If everyone is above average, tax flexibility is a worthy consideration. However, the puts and takes of Traditional vs Roth vs Post Tax investing vary with income level. My thought is that it’s mostly relevant for those with income too low to tax, or much more commonly, those with relatively high incomes and savings, but not so much for most people in between. Then, as discussed in other comments, annuities may play a helpful role.

The majority of retirees will pay a much lower average tax rate on their withdrawals than the marginal rates they paid while saving. For this reason, Traditional Pre-Tax 401K/IRA savings are almost always superior to Roth or Post-Tax savings. The other advantage is you get the tax break just when you need it most, when you are raising a family. I suspect this approach is best for perhaps 8 or 9 out of 10 retirees.

  • One exception to this guideline is those lucky enough to still have substantial pensions; that will increase the value of a Roth.

  • Another exception to this general rule is for people whose earnings are so low that they don’t pay taxes – for them Roth savings provide a long term tax advantage for zero up front cost.

It seems to me that there’s a transition somewhere around $2M+ in savings where there is incentive to consider Roth conversions, Post-Tax savings* or even saving directly to a Roth. All the variables make this an involved calculation. Given that there are cut-offs for Gross Income where SS becomes taxable, and multiple tiers for Medicare rates, all of that is part of the equation (and I have yet to calculate this for myself.)

Tax rates are considered by many to have nowhere to go but up (but that doesn’t mean they will.) Anyways, this could mean that the marginal rate you pay now will amount to less than the marginal rate you pay upon withdrawal. Since high income people ostensibly already have savings that will fill up the lower IRS income brackets, the marginal rate again becomes the relevant compare between the two options, and at some point a Roth may be more advantageous than Traditional. This becomes a matter of trying to balance all your income-related risks (tax, medicare rates).

Post-Tax savings (beyond an emergency fund) are often a bit of a luxury imo, though they are extremely helpful in bridging to SS/Medicare/Pensions. There are also situations where it can become the best option, but I was trying to keep my comments general.

Peter Blanchette
Peter Blanchette
5 months ago

What you’re saying is that we should all contribute evenly to tax deferred, Roth type accounts and taxable accounts during working years so that at retirement the amount of money being taxed during retirement is minimized because the amount of money withdrawn is less taxed because more of it is coming from accounts that have already been taxed(Roth type and taxable). This would not make much sense for higher income types because of all the additional taxes that would be paid during working years that are highly taxed and greatly decreasing the amount that would be saved by those high income earners. For lower income earners it would have little benefit because the marginal rates that they would pay is not going to change very much during working years or retirement years. If people want to have more flexibility at retirement(in essence you are talking about the ability to leave money to heirs with a lower tax impact). There are better solutions than what you are suggesting. One would be to use a deferred annuity strategy that parcels out the income over a period of years to the retiree and then to the spouse and/or children.

Newsboy
Newsboy
5 months ago

I would argue that with just a “3-legged” stool, should one one of those legs fail, it could result in a rather “wobbly” 2-legged income stream post-retirement. I’ve always advocated for an added 4th leg on that stool: Insurance.

First, large face value amounts of life insurance (term is fine) during my working years (typically at least 7-10x multiple of my annual income) to protect and preserve our current family’s current standard of living -and- to also ensure that planned monthly investments into our retirement nest egg could be replaced in the event I died too early in the game and my monthly payroll contributions towards that goal stop suddenly. My wife and kids deserve nothing less. I prefer to call it “love” insurance, FWIW.

As we approach retirement, a second insurance product: plain vanilla fixed annuities funded with roughly a third of our accumulated retirement nest-egg. This approach is designed to provide a monthly stream of guaranteed income for life (similar to a pension or SS). I foresee current non-TQ bond holdings in our portfolio as the primary seed-corn for future “laddered annuity” purchases, (Jonathan has written at length on this laddered annuity approach). Fixed annuity premiums are largely invested by reputable insurers in bonds of varying durations . This helps maintain our desired asset allocation %s in retirement while also providing product diversification at the same time. It may also provide us more latitude with our TQ accounts in terms of what percentage of that money we can comfortably have exposed to equities during our retirement.

Last edited 5 months ago by Newsboy
medhat
medhat
5 months ago

Like almost everything involving personal finance, it is indeed “personal”, i.e. dependent in large part on individual circumstances. I feel both fortunate and typical in this regard. When starting my working career I maxed on qualified, pre-tax 401k contributions, not only for the tax advantage but for the company match (no pension option for me, but yes for my spouse’s work). After maxing that we funded individual IRAs, but that had caps as well. Then the last bucket was personal savings, which fluctuated significantly more as the other buckets had withdrawal restrictions. With the gift of ~25 years of hindsight, what would I do differently, IF… I knew how the market was going to behave? I think the exercise is academic only, because the aggregate enormous bull market since the late 90’s colors my look-back. Notable appreciation has made capital gains on NON-qualified account (and the attendant tax rates) in retrospect significantly more attractive, compared to the comparable gains in my qualified accounts, that upon withdrawal (not in a Roth) taxable as ordinary income. But again, this is hindsight, who knew how (and how much) the broad market was going to rise? All I’m sure of is that saving was a better strategy than spending, and hitting for average, with index funds and ETFs, has allowed me to sleep better than constantly swinging for home runs.

OUTinMinnesota
OUTinMinnesota
5 months ago

The contention of the article is excellent PRE-retirement advice:

To create a strong foundation for our future retirement, we want the assets represented by these three legs to be as equal as possible.

Those already retired (or FIRE) face this matter from a different perspective… the need to monitor YTD income that’s been received… possibly needing to throttle additional taxable income to mitigate tax obligation for the current year.

Skeptical? Please check out the income-level(s) that force someone to pay higher premiums for Medicare Parts B & D; aka IRMAA. It starts in the year one turns 63 and then continues each year after that. Or check out the tax brackets for tax-year 2021.

With that background info in-mind, here’s corollary advice: To ensure that your retirement savings will last for as long as needed, you may need to keep the rate of tax that you pay at (or below) a designated level. It’s something that needs to be done year after year.

To do it, choose your designated tax rate. Then, use an IRS table of tax brackets to identify the taxable-income maximum associated with that designated rate. Then, as the months progress, monitor your taxable income. When necessary, throttle back on T.I.to keep your rate-of-tax within that designated rate.

R Quinn
R Quinn
5 months ago
Reply to  OUTinMinnesota

How does that work if you are also trying to keep up with inflation? I’m thinking $.078 on the dollar may be better than zero.

OUTinMinnesota
OUTinMinnesota
5 months ago
Reply to  R Quinn

Thanks for asking, R. Quinn.

I believe the article itself may answer your question. Someone who invested in a ROTH (the second leg) is able to withdraw funds without incurring any tax liability.

Someone who has invested in taxable investments (the third leg) is able to withdraw funds, paying tax on only the gain, and at the rate-of-tax associated with capital gains.

As always, check with a tax expert for your specific situation. We can’t control inflation. But with good 3-legged investing during pre-retirement, one can (post-retirement) control the mix of income sources to ensure income gets taxed at 22% or lower ($0.78 on the dollar).

Last edited 5 months ago by OUTinMinnesota
Richard Gore
Richard Gore
5 months ago

I like the adage: A Tax Delayed is a Tax Not Paid.

parkslope
parkslope
5 months ago

The contention that each of Phil’s three legs should be funded equally seems arbitrary and lacking in an evidence-based rationale.

Because most of us fund our taxable investments with our earnings, two of the three legs are funded by after-tax money. The contention that the three legs should be equally funded would seem to imply that we shouldn’t max out our IRA contributions if doing so prevents us from equally funding our Roth and taxable investments.

Last edited 5 months ago by parkslope
Phil Kernen
Phil Kernen
4 months ago
Reply to  parkslope

Parkslope, you are right, the idea of equal funding is arbitrary and lacks any evidentiary support, but it keeps it easy to understand. Plus, once we reach retirement and our own unique situations, we are likely to wish for more of one leg in favor of another. There is no one right answer for everyone, so I’m not sure what evidence might be helpful. On another thought, I suppose the tax-deferred balances should be higher since 1/4 of that belongs to the IRS. Thanks for reading and commenting.

booch221
booch221
5 months ago
Reply to  parkslope

My employer didn’t offer a Roth 401 option so I saved the maximum amount in pre-tax accounts. When I have to start taking RMDs in 2025 my income will double. I’ll also be paying a higher Medicare premiums. If I do a Roth conversion I’ll get hit with a big tax bill now.

Thomas Taylor
Thomas Taylor
5 months ago

I can attest to the difficulty of your suggestion making taxable, Roth and regular IRA accounts roughly equal. I started a Roth account as soon as my employer offered them. A lot of employers were reluctant to offer them when they first came out. I don’t know what my tax rate will be in retirement but I simply wanted flexibility with the Roth. I currently have 10/20/70 (taxable/Roth/IRA) mix and skew my current contributions primarily to the Roth account and also amounts to a taxable brokerage account. I might be able to get to a 15/35/50 mix by retirement without an IRA to Roth conversion. Converting some amounts might be a possibility, but not currently in the plan.

As to Richard’s comment, I feel lucky my wife is retired, has a pension, SS and a 401k. This has allowed me to be more aggressive, but not reckless, with my investments.

R Quinn
R Quinn
5 months ago

You raise very important and valid issues. However, those of us who write about retirement, money and healthcare coverage easily lose our perspective, I know I do.

I am one of those dinosaurs with a 50-year one employer pension, SS, 401k and personal investments. The thought of living off only accumulated investments sends chills up my spine.

Reality is most Americans (for valid or other reasons) will not save and invest as good retirement planning would suggest. We expect the middle class to save for retirement, deal with high deductible health plans and use HSAs. Looking at the savings currently accumulated and things look glum.

As much as I wish otherwise, i think the only solution is to increase SS going forward, but to do so with cost shared by all workers and employers. In essence replacing to some extent the pension leg, which never existed for nearly half of all Americans, ever, and which exists primarily in the public sector these days.

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