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Taxes: Pay on the seed you buy or the crop you harvest? PDF Print E-mail
Dairy basics - Management
Written by Donald DeJonge   
Wednesday, 29 August 2012 07:33

Have you ever wondered if you were saving money in the most tax-efficient way? People like to talk about asset allocation (the mix of stocks and bonds in your investment portfolio), but few ever talk about asset location.

Asset allocation is important to a client’s portfolio – but just as important is what type of account those assets are in. The reason for this is taxation. How are accounts like IRAs, 401(k)s, SIMPLEs, SEPs, pensions and profit-sharing taxed differently than life insurance, Roth 401(k)s and Roth IRAs?

In general, the first group lowers your income today, but may increase it later upon withdrawal. The second group allows you to forgo a current tax benefit in exchange for the ability to take tax-free withdrawals in the future, provided certain requirements are met.

For example, with a Roth IRA you must have the account for at least five years and be withdrawing the assets in or after the year you reach age 59 1/2 or because of a death, disability or first-time home purchase (up to $10,000).

Permanent, cash-value life insurance is purchased to provide a death benefit. It builds a value over time. Generally you can withdraw tax-free the premiums paid, but cash value increases beyond the premiums paid are subject to taxation unless borrowed out of the policy.

This type of contract can also provide some liquidity because cash values can be accessed through surrenders or borrowing. Collateral assignments can also be used by your bank if additional capital is needed to secure a loan.

An analogy that I like to use to help people understand the difference between pre-tax and after-tax is to think of it in farming terms; would you rather pay tax on the seed or the crop the seed becomes? So how can we best manage the impact of taxes? When people understand how money is taxed upon distribution, it changes the dynamic of how they save.

Here’s an example of a dairy family in California’s Central Valley. When I first met with them, they were having issues with their company-sponsored 401(k) plan. The fact-finding process revealed that the owners were participating in the plan. Many people may think that making contributions to a 401(k) is not that strange – but consider this.

The contributions into a 401(k) plan are pre-tax, any earnings on the contributions grow tax-deferred. Lastly, all withdrawals are fully taxable at distribution. This means that they would have to pay tax on the crop and not the seed.

In this situation, there are two very important questions to ask: “How much money did you make last year?” Followed by, “How much do you expect to make this year?” For this client, the dairy industry has proved challenging over the past few years.

They showed a loss for 2011 and expected the same in 2012, which was confirmed with their accountant. We added the Roth option to their 401(k) to give the client another tax-efficient “bucket” to save for retirement. This way, they pay tax now on the “seed” rather than the crop. A Roth grows tax-deferred and (provided the requirements stated earlier are met) everything that comes out is not subject to taxation.

While this example showcases clients in a low tax bracket, your situation may be different. If you are in a higher tax bracket, consider the following:

1. Historically, we are in comparatively low tax rates. Today, the top income tax is 35 percent. If you go back to 1986, the top rate was 50 percent. If you can remember back to 1980 and into the ’70s, the top rate was at 70 percent. The highest tax bracket in our country’s history was in 1945 when the top rate was at 94 percent.

2. Clients that grew up in the 1970s tell me that they will retire on less than what they currently need, so their taxes will be lower than they are today. This may be true for some individuals but not for others because tax brackets have widened, making it harder to move out of one rate and into another.

For example, someone making $110,000 a year would be in the 28 percent tax bracket. They would have to take a $26,400 pay reduction to drop down to the next bracket, at 25 percent. Over time, tax brackets have widened and you shouldn’t count on easily lowering your tax rate in retirement.

3. The Bush tax cuts will expire at the end of this year, pushing rates higher, unless Congress acts. The top rate could go from 35 percent up to 39.6 percent.

People who retire entirely on taxable income can be subject to the tax “swings” of our government. If your tax rate is raised 10 percent on a fixed income, that means you have to live on 10 percent less.

Ed Slott, who is considered an authority on IRAs, said it best, “Everyone knows how much they owe on their mortgage, but do you know how much your mortgage is on your retirement?” The amount of tax you owe to the government is like the amount of debt you owe to the bank – and that interest rate is variable.

There are few vehicles that allow you to pay tax now and are tax-free at distribution. Your plans should be customized to your specific tax situation. Ask yourself this, “Does my retirement plan include provisions to manage the impact of taxes”?

It is not what you earn but what you get to keep in your account that is important.  PD

Donald DeJonge is a financial representative with Northwestern Mutual. Northwestern Mutual is the marketing name for the sales and distribution arm of The Northwestern Mutual Life Insurance Company (NM), Milwaukee, Wisconsin, its affiliates and subsidiaries.

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Financial Representative
Northwestern Mutual Life Insurance Company

 

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