Building Wealth In your 40’s to early 50’s

You are established in a career and want to grow your wealth beyond what a promotion or pay raise would provide. You are thinking about your financial future, what happens when you one day retire, and how to provide for your loved ones. To secure your financial future, you will need to make aggressive moves quickly.

Where Have You Allocated Your Savings?

First, assess where you currently stand.  How much money have you allocated to your wealth buckets? Have you evenly dispersed your money among all three or are you underfunded in one or more of the buckets?

Taxable Bucket

Emergency Fund Savings Account Real Estate

Money invested is already taxed; any growth is taxed; real estate income is taxed and profit on sale of real estate is subject to capital gains tax

Tax Deferred Bucket

401(k) • Nondeductible IRA

Total sum including growth is taxed when withdrawn or distributed

Tax-Free Bucket

Roth IRA • LIRP • Roth Conversion

Money invested is already taxed; growth can be distributed tax free

If you are like most people, you have most of your savings allocated to the tax-deferred bucket, you have less than you would like in your taxable bucket resulting in limited access to liquid funds in case of emergency, and you may have little or no money in your tax-free bucket.  While your specific situation may differ somewhat, the common trend among your age group is that very little money has been allocated to the tax-free bucket. Is there anything wrong with the first two buckets? Absolutely not! However, every bucket has its pros and cons and the best way to mitigate those drawbacks is to make sure you have dispersed your funds among all three rather than overly relying on one.  To explain why, the buckets must be examined individually.

Taxable Bucket

This taxable bucket consists largely of individual savings accounts and real estate. Historically popular, savings accounts used to supply a solid avenue for retirement savings.  If you could save $1 million in your lifetime, then you could live stress-free off the interest during your retirement years.  While this was a solid plan for your great-grandparent, the world has changed too much for this to have the same benefits it used to.  Firstly, with advancements in modern medicine, people are living longer than ever.  You are likely to significantly outlive the eight to ten retirement years that used to be the standard amount for Americans, so your savings must last you far longer.

Additionally, banks no longer offer the high interest rates on savings accounts that they used to.  This means that in order for an individual to live off of an interest of $50,000/year, not even a sizable retirement income, you must be able to withdraw $58,238.85/year so that your net after taxes is $50,000.  Assuming a standard 0.50% interest rate, to be able to withdraw this amount from a savings account annually without touching the principle, you must save up a principle of $11,647,770.  This is assuming you have no other taxable income.  If you are in retirement taking money from you 401k, now this savings withdrawal may be subject to higher income tax, meaning you would have to withdraw more and have an even larger principle.

This bucket is great for an emergency fund.  It should be used for quickly accessible cash.  However, for retirement savings, this bucket simply will not provide you the accelerated growth necessary to fund your retirement.

Find more statistics at Statista

Tax-Deferred Bucket

This bucket has gained tremendous popularity with the working population as companies and corporations have nearly done away with pensions. While you should certainly participate in any 401k match offered by your employer, you likely shouldn’t be overfunding this account, nor should you have your blinders on as to why companies push this retirement plan.  A brief look at history should help clarify why 401ks have been so widely adopted.

Prior to 401ks, many companies offered pensions to their employees.  Stay loyal with a company for 20 years and they would pay you a salary in your retirement.  You had no worries about the market, whether your next check would be big or small, or whether you would need to return to work.  When these pension employees were living less than ten years beyond retirement, this plan benefitted both the employer and the employee.  However, when life expectancy continued to increase and employees were living 15-20 years beyond retirement, the growing cost of maintaining pension plans was enough to put companies out of business.  They had to find another way.  Then came the introduction of the 401k.  This put employees in control of their retirement savings and allowed companies to limit how much they contribute to employees’ retirement while also severing their obligation to employees after they retired.  This isn’t to say that companies were duplicitous in the switch.  Not at all.  They were simply making the changes necessary to survive as a company.

From an employee standpoint, the match of 401k contributions is where you receive the most benefit from this retirement plan as you are essentially doubling your contributions.  However, contributing more than the match may not be in your best interest.  The reason employees find the idea of 401k contributions so appealing other than when their company provides a match is because the taxes on that income are deferred.  This doesn’t mean that you won’t pay taxes on that money; it only means that you will pay those taxes later.  People in their 40’s often have one to two kids whom they are deducting from their income taxes.  They may also be enjoying deductions related to their mortgage or student loan interest, all of which will likely not be deductions they will still be eligible in their retirement years.  Take into account also that income tax rates change with every administration.  Will taxes when you retire be lower or higher than when you initially earned the tax-deferred money?  No one knows the answer, so putting the bulk of your retirement income in this bucket may be a tax gamble you didn’t know you were making.

In addition to the tax gamble, you must also consider the risk associated with being vested in the market and ask yourself whether the market will ever go down.  It has happened before and most certainly will happen again.  The only question is when.  Many people waylay this fear with the knowledge that eventually the market will bounce back, but how long will it take to bounce back? Let’s look at some historical examples starting with the most recent.

Source: https://www.morningstar.com/articles/1028407/in-long-history-of-market-crashes-coronavirus-crash-was-the-shortest

As recently as 2000, it took over a decade for the market to recover.  In December of 2019, it took 8 months.  If you were retired and taking distributions from your 401k, liquidating portions of your 401k during those declines would have been devastating.  And in the case of the Lost Decade, could a person afford not to take distributions for over 10 years during his retirement? Perhaps if that person wasn’t wholly reliant on his 401k, he could. Source: https://www.morningstar.com/articles/1028407/in-long-history-of-market-crashes-coronavirus-crash-was-the-shortest

Let’s say instead that these events occurred while a person was still growing wealth, prior to retirement.  In the case of the Lost Decade, he would have lost over 10 years of opportunity to grow his wealth.  However, what if instead of being invested in a 401k, he had been invested in a financial vehicle that only participated in the market during upturns and withdrew during declines? Given the daily rise and fall of the market, he would have then grown his wealth during a time when others were suffering losses. To find out more about these financial vehicles, schedule your free consultation today.

Tax-Free Bucket

Money invested in this bucket has two major advantages over any other bucket when it comes to growing your wealth. First, the interest gained in this bucket is allowed to grow tax free—this is huge. Seeing what a significant advantage this is, the government seeks to limit your contributions to this bucket. For example, you are limited to contributions of $6,000/year in a Roth IRA. This ensures that the bulk of your money will likely grow in environments subject to taxation.

The second great advantage is that distributions in retirement from this bucket do not count towards taxable income. For example, you may have social security and 401k distributions which are both taxed, but any surplus you receive from a Roth IRA, Life Insurance Retirement Plan (LIRP), or annuity isn’t counted toward your income. For the best understanding of this advantage, it’s best to see what happens when this bucket is neglected compared to when it’s used in conjunction with income from the tax deferred bucket and social security income in retirement.

In August of 2021, the average retired worker received $1,558.54 each month through Social Security. That puts the total annual Social Security income for that recipient at $18,702.48. Let’s take a look at the possible tax outcomes for an unmarried, retired worker who needs at least $50,000 annually to pay bills and survive when he supplements his income with 410k and/or LIRP distributions. We’ll use 2021 tax brackets to factor the taxes and assume no deductions in order to keep the examples straightforward.

Using the same circumstances, let’s say the retiree would rather live on $100,000/year, a much more comfortable retirement.  Here are a few possible outcomes.*Minimum required distribution

*Minimum required distribution

What should be clear in both examples is that relying too heavily on your 401k will result in more taxes and the depletion of your 401k balance a lot more quickly. If we look at the first example in the first chart and assume a $1 million balance in this person’s 401k with consistent 2% gains in his 401k annually, his 401k will be depleted in 26 years.  Assuming he retires at 67, he will have enough income to last him until age 93.  However, $50,000/year in income doesn’t provide very much in retirement.  If we run the same scenario with $100,000 in net income/year, his 401k will be depleted in 11 years at the age of 78.  The last thing you want in retirement is to be worried you’ll live too long. Add in the concern that a 401k is unlikely to make consistent gains year after year, factor in a couple dips in the market, and your longevity becomes an even greater risk.

In addition to lowering your tax liability, some of these tax-free financial vehicles are immune to market downturns, allowing you to more aggressively grow your wealth.  To truly diversify for retirement, finding out more about these financial vehicles is your natural next step and Real Life Solutions is here to help. Book your free consultation today for an assessment of your current wealth and growth opportunities.