When it comes to picking out the right investments and accounts for retirement planning, the choices can be overwhelming. With the additional options and riders to financial products, there are literally thousands of different ways to manage your money. In this episode of Money Script Monday, Kevin consolidates the places to save for retirement into three simple buckets and shows you the types of accounts within each one.
Click on the whiteboard image above to open a high-resolution version of it!
Video transcription
Hello, there. My name is Kevin Nuber. Thank you so much for watching today's "Money Script Monday" video.
Out here on the West Coast, we have a couple of restaurants that I like to go to and eat. The first one is one called The Cheesecake Factory. When you walk into The Cheesecake Factory and you sit down, and that waiter or waitress hands you that menu, that menu is going to be about this thick. It's about 20 pages and it has hundreds of different things that you can choose from.
Now, every time I go to this restaurant and I sit down, and I try to choose something, and the waitress ends up coming to take my order, I never have any idea what I want to order.
And the problem is there are just simply too many things to choose from.
Let's contrast that to another very popular West Coast dining option. And that is In-N-Out Burger, one of my favorite places to go, by far.
When you go to In-N-Out Burger, there are three things that you can choose from. They have a hamburger, a cheeseburger and a Double-Double. That's it. Every time you go to an In-N-Out, it doesn't matter if it's 2:00 in the afternoon or 2:00 in the morning, there is a huge line of people waiting to order their food. But no matter what, you can always get your food quickly. Because when somebody steps up to the counter, they know exactly what they want because there are only three options.
In the world of financial planning and picking right investments, the same dilemma is presented to most investors.
You see, if we go out there and try to pick individual investments, there's literally a million different products that you can choose from if we go to individual products.
But for most people, they're going to get bogged down in analyzing all the different choices that they have. And it stops them from doing the thing that they need to do, which is actually save for retirement!
So, what I want to do today is I want to simplify things and just give you three different places that you can put your money, three different buckets where you can put your money.
The first bucket is a taxable account, the second bucket is a tax-deferred account, and the third is a tax-free account. And what I want to show you is the pros and cons in each account, and what is the ideal amount of money that you can put into each account as you save for retirement.
Taxable account
So first off, the first bucket that we have here, this is the taxable account. Now, the taxable account is red because it is the least efficient place that you can put your money. Notice this bucket has a number of holes in it with water coming out.
Many common accounts that you can actually put inside this bucket are things like:
- CD's
- Savings accounts
- Checking accounts
And anything else that's going to be taxable every time you earn interest in it.
How do you know that something is taxable?
Well, at the end of the year, the IRS sends you a letter that basically says, "Hello, congratulations. You earned a certain amount of interest. Some of that is yours and some of that is ours. So please pay us the amount that is ours."
This is kind of like saving for retirement, but putting one foot on the gas pedal and another one at the brake at the same time. You see, you're putting money into the bucket, but at the same time, it's draining out in the form of taxes.
Why Do People Put Money into a Taxable Account?
So, the question I have for everybody is, "Why do people put money into a taxable account?"
Well, the answer is simple. It's that it's liquid.
Generally speaking, when you put your money into one of these accounts, with one stroke of the pen, you can have access to that money. There's one thing that all financial planners can actually agree on and that is that people need a certain amount of minimum liquidity. And usually, they'll say it's about 6 to 12 months of whatever income is.
Being that this is a very inefficient place to put your money, there is a minimum amount of money you want here and that is exactly 6 to 12 months of your income.
So, the question is, "Once you actually fill this bucket up with the sufficient amount of liquidity, then where should you put your money?"
It needs to be something that's more efficient and that comes in the form of a tax-deferred bucket.
Tax-deferred account
This one is blue because it's better.
And a tax-deferred account are things like:
And these accounts all have two different things in common. The first thing they have in common is the way that you put the money in and the second is the way that the money comes out.
You see, let's say you're making a contribution to a 401(k) and you make $100,000, and you choose to put $10,000 into that 401(k).
What you're doing is you're choosing to defer $10,000 of your income by putting it into the 401(k). This means you're actually only going to pay income taxes on $90,000 of income.
You're simply postponing the taxation on that income to some future point. And when you take that money out, it is called "ordinary income”. It's completely ordinary and it's taxed just like regular income that you would ever earn.
So, it's deferred when you put it in, but it's completely taxable when it comes out.
The problem with this is that if you ask most people, "What do you think taxes are going to be like in the future… Do you think that for most people that the taxes are going to be higher, they're going to be the same, or they're going to be lower? The income tax rate, like what do you think the income tax rates are going to be?"
When I ask a group of people that question, they overwhelmingly always tell me that they believe that taxes are going to be higher.
So, why would you postpone taxes to some future point in which you do not know what rate you're going to be paying in and it could likely be higher than what you're currently paying now?
This is kind of like going into a loan agreement with an uncle. Let's say, it's not Uncle Sam, but it's your real uncle. And you ask your uncle, you say, "Hello, listen. I need some money today. So I want to know if I could borrow some money?" And your uncle says, "Sure, no problem. Just let me know how much and I'll lend it to you." And you say, "Okay. Well, I just need to know the terms of this loan and how it's going to be arranged." And the uncle says, "Whoa. Wait a second. I can't actually tell you what interest rate I'm going to charge you today on that loan. You see, when you pay that money back to me at some point in the future, based on my needs at that current time, I'll determine the rate in which I'm going to charge you on that money."
Now, if that was the way a loan actually worked, would you enter into this loan agreement?
Absolutely not.
But the thing is that that's exactly what's happening with one of these 401(k)s. You're postponing the taxes to some future point. And when you pull that money out at some later age, the IRS is going to charge you a tax rate based on their needs at that time.
Not only that, but there are some other significant downsides. You see, you can't keep the money in there forever. At some point, you have to take it out and that's called a "required minimum distribution” (RMD).
If you don't take it out, then you're going to get penalized. Then if you try to take the money too early, you're going to have an early withdrawal penalty.
There are all these strings attached in order to get that tax deferral on that income that you're contributing to.
Why Do People Put Money into a Tax-Deferred Account?
So again, the question is, "Why would people put money into one of these accounts?"
For a 401(k), the answer is simple. It's because you're going to get a company match. And if you're going to get matched 2%, 3%, 4%, 5%, 6%, you should absolutely, 100% of the time, make that contribution to the 401(k), no matter all the negative things that come along with it. That's 100% guaranteed return Day 1 on the money that you put in.
But for a person who makes a lot of income and therefore pays a lot of taxes, we know that the taxable bucket is the least efficient and has the most leaks coming out. The tax-deferred bucket's better, so it only has one hole coming out. So, if we fill this bucket up, the next best place and the absolute best place to put your money is into the tax-free bucket.
Tax-free account
If I asked you, "Where can we put money that's completely tax-free?" the first thing that people are going to say is, "Well, it's a municipal bond." And that's true to an extent, but you have to remember that municipal bonds are not completely tax-free.
To be in this bucket, you have to be completely tax-free. Municipal bonds can have state income taxes paid if you buy them out of state. If you buy a basket of municipal bonds, if you pull those out and there's a gain, you could pay capital gains tax. And then, third is that the interest that you earn on a municipal bond counts as provisional income, which means that it counts towards the amount of money that your Social Security will be taxed at. So, it can cause a tax torpedo in which you pay more taxes on your Social Security.
For all those reasons, municipal bonds are not completely tax-free.
The second place people will say is, "Well, what about a 529 plan?" And although 529 plans are tax-free, you have to use that money for educational purposes. That is not a retirement account.
Municipal bonds and 529 plans are not tax-free for retirement.
The only 100% legitimate tax-free position on this bucket is a Roth IRA. You earn the money tax-deferred and when you take it out, it's completely tax-free. But the problem is that there's only so much money that you can put into a Roth IRA.
Can Bill Gates or somebody who's super-rich put money into a Roth IRA? No. They're not allowed to because they're too rich, they make too much money.
If you make more than $115,000 single or $190,000 as a married couple, then I'm sorry. You make too much money, you're too rich. Therefore, you cannot take advantage of a tax-free account.
If you're under that income threshold, you can take advantage of this account, but you're limited to about $5,500 per year that you can put in. For a person that makes a lot of money, $5,500 a year saving into one of these is not going to give you a healthy retirement.
For that reason, although there's nothing leaking out this bucket, for most people, there's a lid on it that does not allow you to put money into that Roth IRA.
Life Insurance is a Tax-Free Account
I have a few question marks here because there is actually something that is truly, completely tax-free that most people do not talk about and that is life insurance.
Life insurance allows you to grow money inside the policy completely tax-deferred. When you take the money out, it's completely tax-free as well. So it's tax-deferred and it's tax-free when you take it as income.
If you pass away, the money is also completely income tax-free.
So, at every stage of your accumulation, retirement, and transfer of death, it's completely tax-free.
Furthermore, there's no limitations on how much you can put in. As long as you qualify for life insurance, you can put money in, as much money as you can possibly put into one of these policies.
Also, if you're unable to perform two of six activities of daily living or you are confined to a long-term care facility, the insurance company is going to send you tax-free income checks in order to cover some of these expenses.
There's nothing else in the tax-free bucket that people who make a lot of money and have a true tax problem can contribute it to other than life insurance.
For that reason, life insurance can be the most efficient place that you put your money in and has absolutely no contribution limits.
Hopefully, by simplifying all those million different types of investments that are out there, just like that menu from The Cheesecake Factory, instead of looking at a million different types of products, we've simplified it just into three simple places.
The truth is that by properly putting your assets in these three different locations, you can have three, four, five, up to eight years longer of retirement income just by putting them in the proper places.
Down below this video, you're going to see some resources. One of those is a blank worksheet where we have these buckets that you can fill in how much money you have in each one.
You can send that to your advisor, and have a conversation with them about where is the best place to put each one of your individual assets. Thank you, everybody, for watching.
Additional resources