Cutter Family Finances: Tax Free Vs. Tax Deferred, The Decision is Yours

Jeffrey CutterRichard Maclone Photography - Jeffrey Cutter

This week, Allison from Sandwich came to see me. She is a very nice woman, about my age, married with two kids. She has been saving over the years, and has accumulated a nice-sized traditional IRA. Now she wants help taking control of her financial future.

Allison is very aware of the alarming rate of government spending and is very concerned about how it will impact her retirement. She was very interested in learning the difference between tax-deferred investment strategies, such as 401k plans and traditional IRAs, and tax-free investment strategies, like Roth IRAs. She asked whether choosing one rather than the other would affect her family’s financial future.

I explained to Allison that both types of retirement accounts offer advantages that can help her save for retirement. And while an investment plan is important, advanced tax planning should be part of the overall financial plan.

So I asked Allison to reflect on the past performance from our Wizards of Washington (WOW) and today’s economic environment. Upon reflection, I asked her whether she thinks taxes will be going up or down in the future.

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She answered that she thinks they are definitely going up. Good answer, Allison. So I asked her if she would agree that some advanced tax planning could prove crucial to having a secure retirement? She agreed. Another good answer.

I asked Allison to think of it from this angle: Total US government debt is expected to be $21 trillion by the end of 2014. While the debt per citizen equals “only” $55,409, it is the debt per taxpayer that is frightening. Because 47 percent of US citizens don’t pay income tax, the debt per taxpayer equals $151,626. This does not even take into account the unfunded government liabilities that include Social Security, prescription drugs, and Medicare. If you throw our unfunded liabilities, the total of which is approaching $118 trillion, onto our debt firestorm, we have a liability per taxpayer of just over $1 million greenbacks. How is that for a WOW factor?!

Allison agreed that there are only two ways to decrease debt; make more money or cut expenses. So, I asked her where she thinks we are going to get the money. Allison reluctantly responded that she thinks it will probably come from increased taxes. This gal was on a roll.

So, I explained to Allison that if we are worried about increased taxes in the future, then we need to think about whether it is best to hold investments in a traditional retirement account or a Roth retirement account.

Let me explain to you, Cutter Family Finances readers, what I explained to Allison. Contributions to tax-deferred strategies, such as company-sponsored 401k plans or traditional IRAs, are generally tax deductible in the year of contribution, regardless of income. However, if you are covered by a company-sponsored retirement plan and you want to also contribute to a traditional IRA, there are certain phase-out limitations based on income that might reduce or eliminate your IRA tax deduction. But, you can always make a nondeductible contribution to a traditional IRA without any phase-outs provided you have sufficient “earned income” and you report it to the IRS appropriately.

However, the money put away in these tax-deferred plans, plus the gains or interest earned on that money, are taxed at a later date when withdrawals are taken, which is usually in retirement. (Unless nondeductible contributions have been made, in which case, only the earnings are taxed.) Although many people assume they will be in a lower tax bracket during retirement, that is often not the case. (Gross income may decline, but taxable income often does not because certain tax credits and deductions are no longer available.) In addition, tax-deferred savings will eventually need to be withdrawn in the form of a required minimum distribution (RMD) at age 70 1/2 regardless of whether that money is needed. This is reportable income and can create tax consequences for both Social Security and Medicare. This creates what I call a “tax-infested” situation, so let’s look at an alternative.

Now, let’s look at some tax-free strategies, such as Roth IRAs and Roth 401k plans. With these strategies you pay Uncle Sam up front. In other words, the money you contribute is after-tax money. In my opinion, that upfront tax is a small price to pay for tax-free withdrawals on all contributions and gains. However, there are a couple of things to keep in mind here. Just as with tax-deferred plans, you must have earned income in order to contribute to a Roth. In addition, there are certain phase-out limitations based on income to be able to contribute to a Roth. On the other hand, participation in a company-sponsored retirement plan has no bearing on your ability to contribute to a Roth. Another nice feature of the Roth IRA is that there are no RMDs, as there are with traditional IRAs and therefore, the asset can pass onto heirs...tax free. Furthermore, because withdrawals from

Roth IRAs are tax free, they do not hit the tax return, and therefore, there is less of a chance of Social Security benefits being taxed.

It gets tricky out there folks, so just as Allison did, make sure you seek sound financial advice. The financial decisions you make today could impact your financial futures for a lifetime...and possibly generations.

Be vigilant and stay alert because you deserve more.

Jeffrey Cutter, CPA, PFS is the managing partner for Cutter Financial Group, LLC (www.cutterfinancialgroup.com) which provides private wealth and investment management through low risk, low volatility successful strategies. He can be reached at jeff@cutterfinancialgroup.com.

Investment advice is offered by Horter Investment Management, LLC, a Registered Investment Adviser. Insurance and annuity products are sold separately through Cutter Financial Group, LLC. Securities transactions for Horter Investment Management clients are placed through Pershing Advisor Solutions, Trust Company of America, Jefferson National Monument Advisor, Fidelity, Security Benefit Life, FC Stone, and Wells Fargo Bank, N.A. http://tinyurl.com/kwh3m; 2 http://tinyurl.com/ok8glxh; 3 http://tinyurl.com/pksgbt9; 4 http://tinyurl.com/orsds7b; 5. http://tinyurl.com/nuh9sm9.

This column sponsored by:

Cutter Financial Group, LLC, a family owned and operated company, was founded by retirement and investment specialists. We engage high quality, independent wealth managers who specialize in significantly reducing risk during times of volatility, while capturing a large majority of the gains of the upside. This strategy allows our clients to secure a better, and worry-free, retirement.

Learn for about Cutter Financial Group on their website www.cutterfinancialgroup.com

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