Making the Right Decisions to Reduce Tax
All things being equal, we should always choose to defer taxes as long as we expect to pay a lower tax rate in retirement, although this isn’t always the case. It usually is though, among those who only experience market like returns and aren’t generally going to grow their portfolio to the extent where their income ends up being higher in retirement.
We can’t just assume that our income will be lower, and in fact should be striving for it to be higher if we can make it so. In cases such as this, or in any case where we can expect to be more wealthy in retirement than we were during our working years, it might not seem to make sense to still defer tax to retirement when you are working, but it still might.
With those who manage to achieve much better returns, the money that is deferred will also see these higher returns, and therefore will compound very well over time. If the rate of return is significant enough, this can result in gains from deferral that more than make up for the fact that you may have to declare it at a higher tax rate later.
Advisors tend to pay way too much attention to the nominal amounts here, for instance paying a third in tax now versus half of it later, and don’t account enough for other factors such as the effect of growth or the fact that tax brackets tend to move up over time.
Situations that May Restrict Our Investment Potential
We could even say that, as a rule of thumb, one should not really worry about what their tax rates will be in retirement and defer tax on income whenever possible. The only exception to this is if doing so would restrain you from investing in what you want to invest, but that’s the all things being equal principle in action, and if they aren’t, we may then need to reassess.
Other than that, if we’re able to invest in the same things in the same way, deferring tax is almost always better, and in the cases where it might not be, your income is high enough relative to what you made when you’re working that you are better off in any case, so you can’t really go too far wrong with deferring.
Some countries may have rules that restrict what you can defer taxes on your retirement savings with though, and in this case, if the difference between the results that you may be able to achieve outside the rules is superior enough, then deferring may not be the best idea here.
For the most part though, these rules do tend to be pretty flexible for most people, where they can realize their gains within the tax deferred portion of their portfolio without having to worry about their investing being restricted.
Depending on one’s investing style, it may be seen as business income and not investment income, which could disqualify it from the retirement plan. The investor must then weigh the benefits of their desired style and the benefits of keeping the tax advantages.
Certain practices like more frequent trading than the regulators deem suitable, trading on margin, short selling, trading certain types of assets, and so on, may end up disqualifying you. The thinking at the tax office is that you are now out to make a profit, not really considering that this is what all investing seeks, and you may even have to declare your profits as business income rather than the normal capital gains that investors claim, and pay a lot more tax.
In the end though, it comes down to whether you are better off with one course of action over another, which really comes down to how good of an investor you are. If you can realize much better results with your preferred investment strategy, the benefits of doing so can exceed and even well exceed any tax advantages of investing more their way.
If one is having their employer contribute to their retirement plan, there may be and usually is some real restrictions on how you can manage these funds. This can also represent unwanted restrictions, and these restrictions tend to be even less flexible than government ones. You may be stuck long the company’s stock for instance and have no other alternatives.
Once again, this comes down to comparing the potential benefits of each, only in this case we’re looking at the contribution of the employer as well, which makes beating the expected value more challenging. This doesn’t mean we should automatically assume that we can’t though, although it does take some real investing skill to overcome both tax advantages and employer contributions.
Realizing Capital Gains Versus Deferring Taxes to Retirement
One of the biggest things that drives people to simply hold positions until retirement with non-tax- deferred investments is the prospect of having to declare profits as income while one is still working if they choose to exit.
Let’s say we have a certain portion of our retirement savings that isn’t within a tax deferred account. We buy some stock, and it goes up, and for whatever reason we decide the prospects of this position isn’t the best, and want to get out of it and put our money elsewhere.
Many people may be put out by this, and only tend to understand the situation from a tax perspective. They will decide that paying more tax now rather than just holding their positions until retirement isn’t such a good deal, and decide to not exit now.
This usually only occurs to people during bear markets, and rightly so, as long term investors aren’t going to be bothered by shorter term fluctuations, as they shouldn’t be. There are times where even the most committed investors may have second thoughts, although this usually doesn’t occur until way too much damage is done to their positions, and this often is a time where they do want to hang on given we often are close to a bottom at this point.
Realizing capital losses when you’re in a higher tax bracket isn’t usually a bad thing though, but if one is looking to time their positions to some degree, there are going to be some times where they may want to take profits, with the expectation that their positions will deteriorate over a certain period of time.
If you expect to be in a lower tax bracket after retirement though, this can have some tax implications of course, and you will pay more tax in fact in the end by liquidating and declaring your profits now.
Investors therefore have a tendency to look at the tax part of the picture, and don’t really consider that if the drawdown is significant, as we would expect it to be in order to attract the attention of long term investors, the potential gain from getting out of these positions versus holding them can well exceed any tax consequences.
Those who are disposed to time their investments more, looking to be long when it makes sense to, will see these considerations play an even bigger role, as they will be in a position where realizing capital gains may make sense at various points throughout their march toward retirement.
Paying tax later and especially being able to invest this deferred tax money is a good thing in itself, but generally isn’t such a good idea when we are exposing our portfolio to a lot more risk and also lose the potential for greater returns.
If you get to hang on to your tax money and it, and the rest of your portfolio, loses quite a bit of value, this isn’t such a great idea. If this thinking prohibits you from making decisions that would much better serve your retirement goals, such as looking to exit during periods of significant downturn, that’s not helping you either.
Proper tax planning for retirement therefore does have its place, but is not an end unto itself, and cannot be done properly without taking into account the other factors that are present in these decisions.
Ultimately, the goal is to have the most money in retirement that we can when we are saving up for it, and tax considerations may play a role, but they never can be the deciding factor or given more weight than they deserve.