Sometimes the Obvious Choice Isn’t Optimal

Situations arise where it seems like the law was written in our favor. Tax laws change, retirement accounts have their tax advantages, and the best intentions get us excited to take action.

However, it may not always make the most sense to do what seems to be the best or most obvious thing. There are times we can stop, think, and see if the most obvious choice is the best decision for our situation.

For example, the tax law allows an individual with company stock in their 401(k) to take advantage of Net Unrealized Appreciation in their retirement account. To understand what NUA is, please see our previous articles and posts.

In a nutshell, by keeping employer stock in the account until retirement and taking advantage of NUA, the tax law allows significant tax savings on the appreciation of the stock in a 401(k). However, just because it makes the most sense from a tax percentage, it may not be the ideal decision.

Although there may be a big tax savings, there could be a huge tax bill when trying to take advantage of this option. A five or six-figure tax bill or higher, may not be the most ideal choice for a retiring individual. The tax rate as a percentage may be lower because of capital gains, but the overall tax paid as a dollar amount may be higher then simply taking distributions and paying ordinary income tax.

Another example is a Roth 401(k). This allows after-tax money to be saved to the account, and qualified distributions to be withdrawn tax-free in retirement. However, in most cases the tax-free benefit doesn’t come into play until a person reaches age 59.5.

It looks like a great option, but for someone wanting to retire earlier than age 59.5, having most of their retirement income in a Roth 401(k) may not make sense. It may be wiser to save in a non-qualified account, where money can be accessed before age 59.5, without penalty.

Finally, it may be tempting to save a lot for college. People may want to save so much that they ignore their own retirement savings. They’re getting the benefit of saving for college which is great but may fall short of their retirement income needs since much of their money was going to pay for college. Again, it seems like a good idea at first, but the long-term consequences of lost retirement savings may be catastrophic.

The point is not that the above strategies are poor choices. They can be very good financial decisions; but they need to be weighed with the other potential options available, potential consequences, and impact on other financial and wealth management goals.