The three-legged stool is a metaphor for how the post-World War II generation looked at planning for retirement, each leg representing an employer pension, employee savings and Social Security. Each of the three legs was needed to build a strong retirement foundation.
Looking back, that seems quaint. Private pensions continue to dwindle as an option for employees; from 1980 to 2018 coverage by a defined benefit pension dropped in half, to under 20%. And while we are confident that Social Security won’t disappear, demographics dictate that it change to be less generous than before.
With two of our three legs damaged or missing, pensions are a relic of the past for most of us and Social Security is best viewed as a nice benefit, we are left to build that retirement foundation largely by ourselves. We must develop our own savings to support us in retirement. Fortunately, the stool metaphor remains, but it is now about tax flexibility.
The first leg represents your tax-deferred dollars, or qualified accounts. These are 401k accounts or traditional IRA accounts to which you contribute during your working years. The money in these accounts were contributed prior to the payment of taxes and have been allowed to grow tax free. However, when the dollars are withdrawn, they will be taxed at ordinary tax rates. And you must start taking withdrawals at age 70.5.
The second leg represents your after-tax retirement dollars. These are any account with the name Roth attached to it, including 401k and IRA accounts. These accounts are funded with after-tax dollars and are allowed to grow tax-free. When you decide to withdraw any funds, you may do so without paying any taxes on the gains. Furthermore, you are not required to take any withdrawals, leaving you additional flexibility to factor these accounts into your estate plan if desired.
The third leg is represented by traditional brokerage, trust, or any other account that has no tax privileges. Contributions to, or withdrawals from, these accounts do not garner any tax benefits, and any gains or losses will carry associated tax payments or benefits.
To create the strongest foundation, we want to have the assets represented by these three legs as equal as possible. But don’t be worried if they are not. Most of us are in the position of having more tax-deferred savings compared to Roth savings. The idea of tax-deferred savings arose in the 1970’s while the idea behind Roth savings only came about in the 1990’s, and their expansion to the retirement plan world took longer still. Thus it becomes a challenge to strengthen that leg in the most efficient way.
The standard advice once was to max out your tax-deferred savings during your working years. This reduced your tax bill now by reducing your taxable income. It would also reduce your tax bill in retirement because your income and associated tax brackets (and rates) were expected to be lower. This is incomplete advice. Doing so will limit your flexibility when you reach retirement and have to decide which accounts to draw from first. The fact is that we have no idea what tax brackets will exist during retirement. We have no idea what tax rates will be in place when we retire. We just experienced changing tax rates and brackets in 2017 that will reverse in 2026 if they are not made permanent.
Because of all this uncertainty, having options in deciding how to fund your post-retirement lifestyle amounts to having the greatest flexibility to manage our financial lives. In today’s rapidly changing circumstances, flexibility is key and the three-legged stool provides the path.