Tax Priorities for Investors at Every Life Stage

Note: This video is part of Morningstar's February 2015 Tax Relief Week special report.

Jason Stipp: I'm Jason Stipp for Morningstar. It is Tax Relief Week on Morningstar.com, and today we are talking about tax priorities for investors at every life stage with Morningstar's Christine Benz, our director of personal finance.

Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: Tax planning can be or can seem overwhelming. So, maybe if we break it down into decades, it will be a little easier to digest for folks. Let's start in the 20s. What should I think about for taxes in my 20s?

Benz: Well, the key thing you want to think about is getting started on those retirement-savings plans and taking advantage of the tax-sheltered wrappers that you have available to you.

For a lot of folks with their first job, that's going to mean that you will be able to participate in some sort of a company retirement plan. Typically, if there is a default on those plans, it is going to default you into the traditional contributions, meaning that you'll make pretax contributions and you'll have to pay taxes on your withdrawals in retirement. That's a really painless way to get going, so a lot of people may just want to roll with that. And there are certainly worse things that you can do.

But for folks who are in their 20s, it may in fact be a great time to consider whether Roth contributions are the better idea for them. So, in that case, they will have to put aftertax dollars into their 401(k)s--or if they are funding an IRA, those would be aftertax dollars. But the big advantage is that they are paying tax at a rate that may be low relative to where it could go in the future when they are earning more, when their earnings ramp up later in their careers. So, this can be a great time, if you are in your 20s and through the early part of your income cycle, to consider those Roth contributions.

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Stipp: Better to pay those taxes now when they're not as high [so that when] you have more earnings later on when you are retired, you won't have to pay taxes then.

Benz: That's right.

Stipp: So, when I move on into my 30s and 40s, I imagine continuing some of those contributions will also be on the docket.

Benz: It's really important to continue to ramp up those contributions, certainly, as you get raises. And a lot of company retirement plans will allow you to auto-escalate those contributions as the years go by, as you get those raises. So, [it's important to] continue to fund those company retirement plans--to continue to fund IRAs. But it's also important, as you get into your 30s and 40s, to start thinking more about tax diversification. Building assets in Roth accounts, in tax-deferred accounts, as well as in your taxable account--outside of the confines of specific retirement-funding vehicles, just in a plain old-fashioned brokerage account. And the key benefit of that tax diversification really is only apparent when you are retired. You don't see the benefits so much while you're saving. But when you are retired, having built assets in those three key types of accounts will give you more flexibility to control your in-retirement tax bill. So, this is something, ideally, you should start laying the groundwork for while you're in your 30s and 40s.

Stipp: And during that time, a lot of folks are also starting families. So, what family considerations do I need to take into account?

Benz: A few key tax considerations for people who have non-earning spouses: It's really important to make sure that you're taking care of the retirement funding for that individual as well. People can fund a spousal IRA. So, even if their spouse doesn't have income, if the earning spouse has income, you can go ahead and fund a spousal IRA. The contribution limits are the same in that case. That's one consideration.

Certainly, at this late stage--in their 30s and 40s--people are beginning families and it's really important to start those college-savings programs as early as possible. I think it makes a lot of sense to take advantage of any tax-sheltered savings vehicles you can. Morningstar has tended to favor the [529 college-savings plan]. There are lots of investment options that you can put inside of a 529 plan. You also get some really attractive tax-saving features. So, you get that tax-free compounding, tax-free withdrawals for qualified withdrawals, and you may get a state tax break if you contribute to your home state's plan. So, there are a lot of reasons to consider the tax-sheltered vehicles rather than just investing in, say, a brokerage account, which is what a lot of people do.

Another thing to keep in mind: While it's not specifically tax-related, at this life stage, you should start thinking about doing some basic estate planning. At a minimum, when there are children in the mix, you've got to set up those guardianships for the minor children. But it's also valuable to start making sure that your beneficiary designations are in sync with your current family situation and begin working with an estate-planning attorney to draw up those basic documents that we all need, particularly as we age.

Stipp: As I move into my 50s, it starts getting much closer to retirement. It could be a little bit closer to crunch time. What considerations should I have then?

Benz: Presumably, at this life stage, ideally you've come through those college-funding years. Maybe you are really able to ramp up your retirement-plan contributions. Anecdotally--and talking to a lot of Morningstar.com users--this is when they've said they've gotten very serious about retirement funding, once they got those college bills out of the way.

So, one thing you are able to do on Jan. 1 on the year in which you will turn 50 is that you're able to make what are called catch-up contributions to both your company retirement plan as well as your IRA. Take advantage of those as soon as you possibly can.

It's also important at this life stage to be getting serious about the tax-diversification question, making sure that you are continuing to fund the retirement-savings vehicles--not just company retirement plans and IRAs but also continuing to build out the taxable accounts.

Stipp: What about Roth conversions? This might be a time where maybe I do have a lot of money in my 401(k) or Traditional IRA. Should I start thinking about converting some of that?

Benz: Potentially, you could. I think the tricky part with Roth anything is that, by the time people realize that it would be really attractive to have those tax-free withdrawals in retirement, they may be in a pretty high tax bracket relative to where they will be in their lifetimes.

So, I think you want to be careful here, certainly, if you are considering converting some of your Traditional IRA or 401(k) assets to Roth. You want to be sure to consult with a tax advisor. You may be able to convert just enough to do partial conversions over a period of years to avoid pushing yourself into a higher tax bracket as a result of the conversion. So, definitely get some help on this question. But it's certainly something to be thinking about.

For a lot of folks--I think of myself [as being] in this camp--we saved very aggressively in our Traditional 401(k)s throughout our careers and find ourselves a little bit short in terms of the Roth contributions. It's certainly something to think about, getting money over into the Roth column.

Stipp: As I head into my 60s, of course, a lot of things are changing. I'm not putting so much money in, and I'm starting to take money out now. So, what are my tax considerations then?

Benz: Ideally, over your accumulation years, as I've said, you've been building money in the various account types--in your tax-deferred, Roth, and taxable accounts--so this is a time to take a hard look at what is the most tax-efficient sequence of withdrawals for me. There are traditional rules of thumb out there that say you should definitely take your RMDs first if you need to, then take money from taxable accounts, then tax-deferred, then Roth. And that's generally a good framework to have in mind. But in some years, it may make sense to override those rules.

So, this is a great space, if you are not comfortable making these decisions yourself about the most tax-efficient withdrawal sequence, to turn to a tax advisor or a financial advisor who is well versed in tax matters to help you figure out where you will go for your income on a year-by-year basis in an effort to reduce the drag of taxes as well as to preserve the tax benefits that are associated with some of these vehicles--specifically with your tax-deferred and your Roth vehicles.

Stipp: And you mentioned that it might not be a great time in your 40s and 50s to do a Roth conversion because your income is generally higher. But now maybe in your 60s, it could be a good time to do some conversions.

Benz: This may be a sweet spot. In fact, in talking to people who specialize in this area, that period of time from when you retire to when you need to begin taking required minimum distributions from your Traditional IRAs and 401(k)s, that's kind of a sweet spot for folks to control their income. They don't have that salary income coming in the door, and so they are able to control their distributions from their portfolios to some extent, and they are not yet subject to the RMDs. So, this can be a great period of time to consider whether doing those Roth conversions may be advantageous. You may be able to keep your income down in a way that you will not be able to do once those RMDs start.

Stipp: Also, in the 60s, we'll be making decisions about when we claim Social Security, and there are some tax implications there as well.

Benz: There are--particularly for people who claim Social Security early, prior to their full retirement age, and they are going to continue to earn a salary of some kind during that time, or have earned income during that time. It's important to know that a penalty will apply to their Social Security benefit. So, stay mindful of that if tapping Social Security plus working is part of your plan. And certainly, anyone receiving Social Security at any age needs to keep in mind this idea of provisional income, in that a portion of your Social Security benefit is, in fact, taxable if your provisional income exceeds certain levels. Those levels are pretty low, so this may not apply to a lot of our viewers. But certainly, for individuals who aren't pulling in a lot of income, it may be valuable to consult with the tax advisor just to make sure that if you can stay under those thresholds that you are doing so.

Stipp: And if you are in your 60s, you might also have some grandkids around. You could consider funding 529s for them.

Benz: Right. We talked about the benefits for parents funding 529s. They are exactly the same for grandparents. So, the grandparent can obtain that state tax break on the grandparent's home-state contribution, and the money inside will also enjoy tax-free compounding and tax-free qualified withdrawals.

Stipp: And then when we reach our 70s, we have these things called RMDs, required minimum distributions. What do I need to know about those?

Benz: The key thing is that you've got to take them. There is no way to circumvent your required minimum distributions--otherwise, you'll pay a huge penalty equal to 50% of the amount that you should have taken but didn't. So, you've got to take them. But there are ways to make sure that you are being strategic about the withdrawals. We've talked about this in the past. I think it is really valuable, once you get into RMDs, to strategize about where you are pulling them from so that it also makes sense to you from a portfolio standpoint.

So, for example, coming out of a period like 2014 where we saw pretty good appreciation in the equity market, for a lot of retirees, pulling their RMDs from their highly appreciated equity accounts can be a great way to restore balance in their portfolios.

It's also valuable, if you are a charitably inclined person, to think about taking your required minimum distributions and forking them directly over to charity. From a tax standpoint, that will tend to be preferable to taking the distribution, then paying taxes on it, and then taking a deduction. You're going to get more bang for your buck by doing that qualified charitable distribution.

Stipp: Christine, great tax tips for a lifetime. Thanks for joining me.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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