Tax Planning

I recently picked up a new personal finance book through a new-to-me channel: a recommendation from a coworker. In a company meeting there were some announcements about changes to our 401(k) plan, and afterwards we got to chatting about our own strategies around retirement savings. I was delighted to hear that she is familiar with the Bogleheads - I think this is the first time I've met someone in real life who is also familiar with that community! Though, to be fair, I don't ever initiate conversations about Bogleheads in particular or finance in general, so there could very well be More Of Us around.

 

She described a book she was making her way through, Tax Planning To and Through Early Retirement. I've been aware of FIRE (Financial Independence, Retire Early) for some time; when I first heard about it, the movement was strongly associated with "Mr. Money Mustache" and an ethos of extreme frugality. Early retirement isn't really compelling to me; I'm lucky enough to have a job in software development that pays pretty well and that I enjoy doing; if I were to retire, I'd probably keep on developing software just for fun, so as long as I can keep getting paid for it I'll probably keep doing that. But the FI part of FIRE is attractive to me. I associate financial independence with security, confidence, opportunity and flexibility. Moving closer to that goal has been beneficial to my overall well-being and happiness.

Anyways, this book is primarily aimed at the RE part of FIRE, so I'm personally not exactly in the target audience, but I still found it very useful. Even early retirees eventually become regular retirees, so we all end up at the same place eventually. And it's helpful to have a unique focus to a finance book: in this case, it's almost entirely about taxes, and doesn't waste time on other topics like budgeting, investments and so on. 

Like most personal finance books I read these days, I didn't get a whole lot of brand-new information from this book, but I did get a lot of reinforcement about best practices, as well as a deeper understanding of why things work. And I did learn a few things that were actually brand-new to me. One specific topic that I was researching just a couple of years ago is how RMDs work when you have multiple retirement accounts. The authors explain it very clearly in this book. RMD rules are actually different depending on the type of the account. For traditional IRAs, all IRAs are pooled across all accounts (even from multiple custodians) when determining how much RMD is required and how it is taken. So, if you have three IRAs, you can satisfy your RMD by withdrawing from all three accounts, or withdrawing the total required amount from a single IRA. But the rules are different for defined contribution plans like 401ks and 403bs. For those, each account has its own separate RMD requirement. So if you have three 401ks, you need to take a separate RMD from each one of them; if you take a larger amount from a single 401k, it doesn't satisfy the need to withdraw from others. This situation is further reinforcement for the general recommendation that on retirement workers should generally consolidate all of their 401ks and 403bs into an IRA.

One of the central points of this book is what they call The Compelling Three: ideally, employees should generally try to maximize their traditional deductible 401k (or 403b, etc.) contributions, and also build up a Roth IRA and a taxable brokerage account, prior to retirement. That's what I've ended up doing, and reading this was very validating and reassuring. They get into the details of why and how this is helpful. The upshot is that it lets you shape your taxable income in retirement. In some years, you might want more taxable income, to fill up the lowest income tax brackets or avoid Medicaid eligibility. To achieve that income, you want to withdraw from a tax-deferred account. In other years, you might want to get more income for life expenses but want to keep taxable income low to retain eligibility for ACA credits or other benefits. In those cases, drawing from a Roth would be good. And if your income is low, you can sell appreciated stocks in a taxable brokerage and pay 0% long-term capital gains, which in turn could be used to fund a Roth.

Years ago, my 401k started offering a Roth option. I was undecided on whether to do it, so for a while I was splitting contributions 50-50 between the Roth 401k and the regular pre-tax deductible 401k. After about a year or so I switched back to having it all be pre-tax traditional contributions. The authors of this book strongly agree, and I really like the simplicity of their message: "Pay tax when you pay less tax." Essentially, during our working years, we're usually in higher tax brackets, and every dollar we can deduct is deducted from the highest marginal tax bracket (like 24%). In retirement, though, we're starting from an income of $0, and every dollar we withdraw from our tax-deferred accounts goes against the lowest marginal tax brackets (like 10%, 12%, etc.). Saving 24% on tax today is far better than saving 12% on tax decades from now.

They directly address a lot of the concerns other people have. One common question is what will happen to tax rates in the future, and a widespread assumption that they will go up as the US struggles with an increasing federal debt. They have a very data-focused way of looking at this. First they describe the unlikelihood that future tax increases would fall on seniors, given what a politically powerful bloc they are, and they show how seniors have received increasingly favorable treatment over the last 30+ years even as our debt has continued to climb. But they also say, "Well, what would happen if tax rates did go up 50%?" They create hypothetical scenarios as a sort of pressure-tested extreme outcome, and show that even in these extremely unlikely cases the person who made traditional contributions during their working years would come out ahead over someone who contributed to the Roth 401k.

Another concern is the so-called "Widow's Tax Trap." This is the scenario where one spouse dies; the surviving spouse's expenses will likely drop somewhat but not by half, but they will start to file as a single instead of married and thus may be elevated to a higher tax bracket. Here too, they run the numbers and show that while it is a disadvantage, it isn't nearly as bad as people fear. Even with this "penalty" the widow is still almost always better off than she would have been contributing to a Roth 401k; and, they point out, that isn't even considering the larger context, which is that this couple likely already had decades of highly advantageous tax rates, and the surviving spouse will often only have a few years of single filing. They eventually land on a scenario where the widow does end up in a worse position: but, they emphasize, this scenario required the 80-year-old widow to have $20 million in wealth. As they say, she is rich! Her lived experience doesn't suffer from needing to pay 32% tax instead of 24% tax on the last $10,000 of her income.

As the authors say from the start, they wanted to avoid any kind of fear-mongering in this book. Many books and articles about retirement seek to alarm people and make them feel like they'll fail if they don't do specific things. The authors do have recommendations, but they continually show how even sub-optimal strategies still have decent outcomes. As they keep pointing out, this is because our progressive tax system is actually very generous to retirees, and has become even more so over the years.

As I read more about finance, I start to recognize that sometimes two authors are describing the same concept or phenomenon through opposite perspectives: they seem like two different things, but are really two sides of the same coin. One of the first times I recognized this was reading William Bernstein after Thomas Piketty. Essentially, Piketty writes "Increasing the rate of return on capital results in further concentration of wealth among current owners of capital [derogatory]", while Bernstein writes "Increasing the rate of return on capital results in further concentration of wealth among current owners of capital [complimentary]". In this new book, the authors repeatedly state that they prefer to hold US equities in a taxable brokerage account, primarily due to the current low dividend yield of stocks. Which makes sense, but... the current low dividend yield of stocks is basically the same phenomenon as a historically elevated P/E ratio. Most of my reading has focused on this as a negative: eventually, there will need to be a return to the long-term historic mean, which predicts a significant fall from today's high asset prices. But these authors see the current situation as a positive: you can hold a large store of wealth without being forced to accept a large amount of taxable ordinary income.

All in all, I would probably place this book solidly in the second tier of recommended reading for personal finance. It's most helpful for someone who already has clear goals in mind and a basic grasp of the fundamentals. It's nicely focused on a particular topic, taxation, that is important but not the end-all-be-all of a retirement journey. The knowledge it shares isn't esoteric: at the heart, it's just urging most people to save as much as they can in their employer's 401k or similar plan, and supplement that with a Roth IRA and a taxable brokerage. But their focus lets them dive into the details, showing with numbers and tables why and how things work the way that they do. This is the sort of book that would help someone transform that goal into an actionable game plan. All in all, a valuable option to have!