Avoiding Tax Paralysis (The Importance of Tax Diversification)

I’ve never understood why there exists in most American’s minds, such a negative association with paying taxes (as in “death and…”). Doesn’t the fact that a person has to pay taxes mean that he or she has made money? I get that there are any number of specific objections people may have, depending on their own personal political or socio-economic position, to how much they are taxed, or to what the money is used for etc., but it has always struck me as an odd dichotomy that something relatively positive can carry such a negative connotation in most people’s minds. Taking it one step further, some even view the paying of taxes as a kind of penalty. For many retirees, who have saved for most of their adult lives into tax-advantaged savings plans, and now must pay the piper as funds are withdrawn, it often causes a negative emotional response we have come to call “Tax Paralysis”.

A recent experience with a new client illustrates the problem.

Joe and Rhonda worked for many years, and having done their research, and followed the conventional wisdom, saved for their retirement using mostly tax-qualified and tax-deferred accounts (i.e. Traditional IRAs, 401(k)s, 403(b)s, TSAs, Etc.).  In doing so, they received upfront federal and state tax deductions when they contributed to their accounts, and enjoyed tax-deferral all along the way.

Now, Rhonda and Joe are both over age 60, recently retired, and are using the money they so diligently saved over the years to enjoy their well-deserved retirement. At their last meeting, they expressed to me that they would like to take the whole family (children and grandchildren) on an Alaskan Cruise.  The cost for the trip would be $25,000, and so I explained that we would need to take out closer to $42,000 from their retirement accounts to cover the cost of the trip, plus pay the Federal and State taxes on the withdrawal. According to their financial plan, they could certainly afford this amount without derailing their retirement goals, but when they heard this, they became extremely discouraged, and felt almost as if they were being punished somehow for removing funds from their retirement accounts. They have subsequently put off the trip, and continued to let the money accumulate in their accounts, despite my repeated assurances that they could easily afford the trip. The result, of course, is that now they are not enjoying the money they have spent a lifetime accumulating, as they always envisioned, and they won’t allow themselves to have the invaluable experience of traveling with their family, and creating those beautiful memories for everyone.

The psychology of the example above is not, in our experience, an issue of one client’s relationship with money, but rather, an all-too-common phenomenon which we expect to encounter more and more as millions of baby-boomers make their way into retirement over the coming years.

There are a few ways to address the issue of “Tax Paralysis” with clients, the first of which is to begin to help them readjust their thinking around savings and taxes. It is important to make sure clients understand that saving into tax-qualified accounts is not a way of avoiding taxes, but simply a way of deferring them. A change in mind-set, away from viewing paying taxes on money that has never been taxed before, as some sort of a ‘penalty’, is a good place to start.

Addressing the psychology around “Tax Paralysis” is often the only tool we have with clients who are already retired, but for those still saving, there are some concrete steps we can take to help mitigate the negative effects of this issue, the most important of which is based on what we call the “Tax Triangle”.

Simply put, the “Tax Triangle” is a way to diversify a client’s investment dollars through the use of different investment accounts, so that not every dollar withdrawn in retirement is taxed at their top tax bracket. As the name implies, a properly implemented “Tax Triangle” has three legs: qualified accounts, non-qualified accounts, and tax-free accounts.

Qualified Accounts

To encourage American workers to save for their own retirements, the government offers the dual incentives of a current tax deduction and tax-deferral along the way for money saved into certain designated retirement accounts.  The most common of these is the 401(k), but there are others as well, including Traditional IRAs, 403(b)s, SEP IRAs, TSAs etc. Dollars saved into those accounts receive a current tax-deduction, meaning the worker saves money on taxes at the time of the contribution. Tax deferral in these accounts means that no taxes are due on any earnings (dividends and capital gains) in the account until funds are withdrawn.  Since those earnings can also generate income, the account can theoretically grow more quickly than it would if funds were needed to be withdrawn to pay the tax due each year (the power of compounding). This is the reason most workers believe qualified savings vehicles are the best places to save for retirement, and why so many have the vast majority of their retirement savings in them.

To enjoy this tax-deferred growth, the investor generally gives up the right to take money out of their account without penalty before age 59 1/2.  If they do withdraw early, they will likely owe whatever ordinary federal and state income tax is due, plus a 10% federal penalty and possibly state-imposed penalties as well (there are some exceptions to the early withdrawal penalties).

The common misconception is that contributions to these types of accounts are tax-free (there are no free lunches when it comes to taxes). Instead, taxes are due when the money is withdrawn from the accounts, usually in retirement.  Additionally, these funds are usually taxed at the investor’s highest ordinary income tax rate, currently as high as 39.6% federal, plus whatever their resident state adds on.  In other words, no taxes up front, but the most taxes when distributed. The conventional wisdom is that once a worker is retired, they will be in a lower tax bracket than when they were working, which will result in a tax savings, simply by deferring the paying of taxes until retirement. This is not always the case, however, and is the thinking that often results in “Tax Paralysis” in retirement.

Non-Qualified Accounts

Non-qualified accounts are those that do not receive any special tax treatment.  These types of accounts are commonly held in a client’s individual name, or are joint accounts, transfer-on-death accounts, accounts with trust ownership, etc.  People often use this type of account only as a last resort because they believe that investing as much as possible in tax qualified accounts, is always their best option for the reasons already discussed.

Non-qualified accounts, despite not providing any current tax deduction or ongoing tax deferral, do offer some advantages.  When funds are withdrawn from these accounts, only the gains are taxed (plus any losses can often be written off), and the gains are taxed at the more favorable capital gains rates (not ordinary income tax rates).  Federal capital gains rates (currently as high as 20%) are much lower than federal marginal income tax rates (currently as high as 39.6%). Additionally, there are no penalties for withdrawing funds from a non-qualified account prior to age 59 ½.

Tax-Free Accounts

The third leg of the tax-triangle is made up of potentially tax-free investments.  The most common type of account that falls into this category is the Roth IRA.  When using a Roth IRA, an investor does not receive any upfront tax deduction, but he or she does get the advantage of tax deferral, and, if managed correctly, the funds can be withdrawn completely tax free in retirement. 

Here’s an example of the “Tax Triangle” at work:

Let’s say we have a retired couple that needs to take $60,000/year from their accounts to provide for their retirement income.  Under current tax rates, they could take $37,000 from their qualified accounts, bringing them up to the top of the 15% marginal tax bracket. The next $15,000 could be taken from their non-qualified account, where they would pay a flat 15% in capital gains taxes.  The remaining $8,000 could then be taken from their Roth IRA, and no taxes would be due on those funds.  In this example, the couple would be able to get the $60,000 they need, without having to take so much from any one account as to push them into a higher tax bracket.

As with most things financial (and often non-financial as well), diversification is the key.  Ideally, when clients reach retirement, we would like them to have some money in qualified accounts (for the current deduction and tax-deferred growth), some money in non-qualified accounts (for potentially lower capital gains rates), and some money in tax free accounts (for tax deferral and tax free distributions).  If we knew, today, exactly what tax bracket each client would be in when he or she eventually retired, it would be easy to have absolute clarity as to what accounts to fund now.  However, since it is close to impossible to predict what tax bracket a client will be in many years down the line, or what changes may be made to the tax structure in the next 10, 20, or 30+ years, we believe the best advice is to have eggs in as many baskets as possible. 
We try to coach our clients not to fear (or loathe) taxes. After all, paying taxes essentially means they have made money. However, changing the psychology is hard and can take time, so planning a strategy upfront to take advantage of whatever structure exists in the future is paramount. That way, when it comes time to start taking withdrawals and enjoying the fruits of their labor, (or taking the family on that Alaskan Cruise), we can help our clients control the tax situation in a much more efficient and less stressful manner, and avoid falling into the “Tax Paralysis” trap.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.