How to Structure a $3M Portfolio to Save $1M in Retirement Taxes

Full transcript includes subheadings:​

Hello, everybody. My name is Ty Bernicke. And as a firm, Bernicke Wealth Management has been helping people with retirement for over 40 years now.

And one of the things that’s crazy to me is how much people overestimate they can save in taxes on an annual basis and underestimate how much they can save during the duration of their retirement years, simply by implementing a few different simple strategies, which I’m going to show you today.

So I’m going to show you how to structure a $3 million portfolio to save over $1 million in retirement taxes.

Understanding the Three Retirement Buckets​

And the thing that I can’t emphasize enough is the decisions you make early on in retirement can significantly affect the taxes that you pay over your entire retirement. And to understand the different strategies we’re going to be going over, we’re going to be talking about three different investment buckets that people commonly have their money diversified into for their nest egg for retirement.

And for simplicity, the examples we’re going to work off today to illustrate this with you, we’re just going to assume, again, to keep this real simple, that our hypothetical investor has $1 million invested into the tax deferred bucket, $1 million invested in the tax free bucket, and $1 million invested into what we call the non-qualified bucket. The tax deferred bucket would include things like IRAs, 401(k)s, 403(b)s, 457(b)s deferred compensation plans.

All of these different types of retirement accounts work similarly from the perspective of when you put money into this bucket, it goes in on a pretax or a tax deductible basis, and the money grows on a tax deferred basis. However, when you take money out of this bucket, 100% of what you withdraw generally is subject to ordinary income tax at a federal level and potentially a state level, depending on the state you live in.

When you contrast that with the tax free bucket, the tax free bucket, you generally don’t get the big tax savings up front, but the money grows tax free and can be taken out 100% income tax free if taken out for qualified reasons. So this would include things like Roth IRAs, Roth 401(k)s, Roth 403(b)s, Roth 457(b) accounts.

The final bucket is what we call the non-qualified bucket, which to me essentially means non retirement.

How the Non-Qualified Bucket Is Taxed​

When you put money into this bucket, you generally don’t get any special tax advantages up front. You usually get a 1099 issued to you every year, showing how much you have to report on your tax return and either the dividends or depending on the type of investment you have, the interest income that you’re earning on this bucket.

And so we’re going to start off by going over one of the first strategies on how to minimize your tax cost ratio within your non-qualified bucket.

The Types of Investments to Avoid in the Non-Qualified Bucket​

The types of investments that are highly inefficient to own in this bucket would include things like corporate bonds, where 100% of your interest income is subject to federal income tax and state income tax.

Government bonds. 100% of the interest you make with government bonds is subject to federal income tax but not state income tax. But still, highly tax inefficient.

Stocks can be much more tax efficient because when you buy a stock and it appreciates in value, you don’t pay the tax on that until you decide to sell it. And then you only pay tax on the growth portion.

And if you own the investment for over a year, the capital gains tax is taxed at a lower rate than ordinary income taxes. So not only do you get to delay the tax, but when you do decide to pay it, when you sell the stock, you pay it at a lower rate. So you have more and more of your money working for you.

And if you own a bunch of stocks and mutual funds that work similarly, however, the mutual fund manager is going to be buying and selling stocks within your mutual fund as they deem fit, with no care in the world of what your tax situation is. So we’re going to talk a little bit about that next, because that’s ultimately what a tax cost ratio is.

What Tax Cost Ratio Means​

And some of the most popular investments people will own in the non-qualified bucket that are earmarked for retirement will be invested in mutual funds that either invest in stocks and bonds. And there’s a company called Morningstar that actually shares with you tax cost ratio, which essentially is the percentage of your earnings you’re losing to taxes on an annual basis.

And they usually list this for people in the highest tax bracket. So this might not be directly applicable to you depending on your tax rate. But the general premise is sound regardless of what your tax rate is. So a very highly tax efficient mutual fund owned in that non-qualified bucket would have a tax cost ratio that only robs you of about 0.3% per year.

So if you had an 8% rate of return on the investment but lost 0.3% to taxes, your net return would be 7.7%. A very highly tax inefficient cost, tax cost ratio would be 5% per year. But I would admit that’s very extreme.

The Impact of Small Differences in Tax Cost Ratio​

But let’s take a look at an example of how significant of a difference having kind of an average to maybe slightly above average tax cost ratio makes versus a highly effective and efficient tax cost ratio.

So again, earlier we said that the non-qualified bucket would have $1 million invested into it. And if the current tax ratio is 0.8% and we said, gosh, you know, I’m just going into retirement and I just found out about this strategy. So instead of owning this throughout the duration of my 30 year retirement, I want to own a different mutual fund that has a more tax efficient cost ratio of 0.3%.

If we assume the average rate of return of the investment is 8% and we assume a 30 year retirement, the savings from going from 0.8% to 0.3% over 30 years is over $1 million.

That one tax strategy alone can literally save you over $1 million in taxes on just the non-qualified bucket over a 30 year retirement.

So again, not exactly chump change in the long scheme of things. And so making sure that that non-qualified bucket is owning highly tax efficient investments is hugely important. Strategy number two, which is another relatively simple strategy that I would call the low hanging fruit strategy, is how you allocate the investments within the IRA bucket versus the Roth IRA bucket.

Strategy Two: Allocating Stocks and Bonds Between IRA and Roth​

So now we’re just isolating the IRA and the Roth IRA. And if you can see here for this example, I’m assuming that stocks made 9% per year over the long term. Bonds make 4% per year. And for this example, we’re just going to assume that this person has a risk tolerance that suggests they need 50% in stocks, 50% in bonds.

I’m just doing that for simplicity to help you get the general concept. And for this one, we’re just going to use a ten year time horizon because it gets almost unbelievable if we go out 30 years. And so I wanted this to be realistic as we could make it. And this is a relatively super simple strategy that do it yourselfers can do.

Or your financial advisor should be thinking about this. But generally, nine times out of ten when people come into our office, they haven’t organized their investments correctly for this. So when you think about the difference between an IRA and a Roth IRA, again, if somebody was to ask us, well, which of those buckets would you like to be larger, and which of those would you like to be smaller if you could snap your fingers?

Well, most people would say, gosh, I’d like to have more in the tax free bucket because that’s more money I can withdraw absolutely free of income taxes if I take it out for qualified reasons. But for this first example on the left, we’re just going to assume the investor wanted to stick with the risk tolerance. And so they put 50% in stocks, 50% bonds in their IRA.

And they did the same in the Roth IRA, 50% in stocks, 50% in bonds. And over ten years, you can see the accounts grow to the exact same value because they have the exact same allocation and the total of the two accounts together is a little over $3.8 million. If instead of doing it this way, we say, well, gosh, why don’t we just put all of our bonds in the IRA to stifle the growth of the bad bucket and put all of our stocks to accentuate the good bucket, because most of us would agree over time.

Generally, stocks do better than bonds, although they’re undependable over short periods of time. Over long periods of time, they tend to do better. And again, for this example, we assume stocks made 9% per year over the ten year time horizon, bonds made 4%. Well, you can see the ending value of the two buckets is exactly the same as the previous example.

The difference is the bad bucket has less than $400,000 in it, and the good bucket has an additional $400,000 in it. So you have $400,000 more sitting in tax free monies and $400,000 less sitting in monies that are going to be subject to ordinary income tax when we take it out. But we still have the 50/50 allocation. So we still meet the risk tolerance goals of the portfolio.

And so allocating money, allocating your growth assets and your bond assets in the correct buckets is extremely important.

Strategy Three: Using Buckets to Manage ACA Health Insurance Costs​

Finally, this strategy number three that we’ve seen highly influential. And if laws don’t change in the very short term, this is going to be even more important because subsidies and tax credits for people to reduce certain types of health insurance before Medicare kicks in, they’re not as good as they used to be, in a nutshell.

And so I’m going to share with you an example of how it works in my home town. Again, we work with people all over the country. But this is how it works in Wisconsin, in Eau Claire County, where our firm resides. So let’s just say we have a married couple, 62 years old, in Eau Claire County, and they need health insurance to get them to Medicare age.

We’re assuming they retire before Medicare kicks in.

And if they don’t have health insurance provided to them from a previous employer, frequently, what people will have to do in that situation, one of the options they have is COBRA, which is a temporary option. Usually, a lot of people eventually end up on the exchange or buying ACA insurance, also known as Affordable Care Act insurance, also known as the exchange, also known as Obamacare.

Those are all terms for the same thing. They’ll buy insurance through the exchange. And when you do this, the cost of your health insurance to get you to Medicare age at 65 is dependent on your modified adjusted gross income. And take a look at how this works in Eau Claire County. This is similar to other states and counties around the nation, but some of you might have a state sponsored version of this that is less severe.

But most states use the exchange and don’t have their own state sponsored version. Regardless of if you have the state sponsored version of Affordable Care Act insurance, or you’re actually on Affordable Care Act insurance, the premise is relatively similar from the perspective that as your modified adjusted gross income goes up, the cost of your insurance will also go up.

The ACA Cliff Example in Eau Claire County​

So you can see if a person’s modified adjusted gross income, which I’ll explain what that means in a minute, is a little over $21,000, their annual premium is next to nothing, only $444, and at $84,600 of modified adjusted gross income, you can see the premium, it’s still, it’s not great. It’s gone up a bunch, but it’s $8,426.

And some would argue that’s not affordable. Some would argue it’s affordable, but it’s more reasonable than what I’m about to show you. Look what happens if you go $1 over $84,600. So by going over the cliff, this is called once you go over that cliff, look at what happens to the cost of health insurance. It literally goes up by close to $32,000.

In my home town of Wisconsin, in a small town with a relatively low cost of living relative to other big cities and around the nation with clients that we work with. So a huge step up in costs. So if you can avoid this cliff, it’s hugely important that you do. So how do you do that?

What Counts Toward Modified Adjusted Gross Income​

Well, you got to know what constitutes modified adjusted gross income. What counts are things like if you still are working part time and you have income coming in from that, Social Security income counts, pension income, monthly pension income counts, distributions from IRAs count. If you have a small business, the net business income would count. Even municipal bond interest, which is typically income tax free, actually counts towards modified adjusted gross income in this example, and income, dividends and capital gains from that non-qualified bucket also count.

More important than that, what does not count. Qualified distributions from Roth IRAs don’t count at all. The basis of your investments in the non-qualified bucket also do not count at all. So if you have enough money in those two buckets here, organized correctly, you can use that as income to get you to 65 and avoid turning on some of these other things if it makes sense.

So again, avoiding unnecessary health insurance costs are something that can be easily planned for if you know how to organize those buckets.

Final Takeaway and Next Steps​

But at the end of the day, if there’s one thing you can take away from this short video, it’s get your buckets organized correctly because it can make a world of difference and in this example, well, north of $1 million of saved taxes during the duration of one’s retirement.

And if this is something you’d like to talk with somebody, our certified financial planners do this all day, every day on an educated basis. This is what we specialize in. You can set up a 15 minute call to talk to them, to see if you’re on the right track, or to get a second opinion. And you can do that by going to our website at Bernicke.com, or clicking on the link that we’ve included in this video.

I really appreciate your time today and hope you learned some valuable things. Thank you once again.