By Danny Toney
Paying taxes can be painful, just as painful as someone eating 46% of your freshly baked, warm, mouth-watering chocolate chip cookies. Some of us, totally disregard the number that tells us how much we paid in taxes, and choose, instead, to only focus on the refund numbers, for the sake of a positive emotional boost. While we, at Signal Wealth, believe that you should legally pay as little in taxes as possible, many people can get caught in a tax trap by only focusing on the current tax year, instead of looking years and decades in advance.
Let’s start here…
What are some types of tax-deferred accounts?
Some of the most common tax-deferred accounts are traditional individual retirement accounts (IRAs) and traditional 401(k)s. What does tax-deferred mean in this context? It means that the money you contribute to one or both of these accounts is NOT taxed at the moment of earning or contribution. Once the money is in the account, it continues to grow completely tax-free. You are only taxed on that money when you withdraw it from the account.
Common financial advice suggests that maxing out your traditional IRA and/or traditional 401(k) is the best option. This advice is assuming that your future/retirement tax bracket will be LOWER than your current tax bracket. Therefore, by deferring taxes now you will end up paying less taxes overall. This is sound advice if the assumption is TRUE. However, that assumption is not always true.
What is a Roth IRA or Roth 401(k)?
They are both personal retirement accounts. Roth accounts are “all about paying taxes upfront and allowing tax-free distributions later on in life” (Rewirement, pg. 41). In this aspect, they are essentially opposite of traditional retirement accounts.
|Traditional IRA or Traditional 401(k)||
|Roth IRA or Roth 401(k)||
There are other details associated with Roth IRAs and Roth 401(k)s, but those can be a subject for another article.
Why is deferring as many taxes as possible not always the best option?
One requirement for all IRAs (traditional, SEP, SIMPLE, etc.) and employer sponsored retirement plans (profit-sharing plans, 401(k)s, 403(b)s, etc.) is required minimum distributions (RMDs). RMDs are required to start in the year a person turns 70 ½ years old and are completed every year after that until death. When a client completes an RMD for the year, they must pay the appropriate taxes (taxed as ordinary income). In a nutshell, the government requires RMDs in order to guarantee they get their tax money.
The way RMD calculations are structured is to attempt to require a person to distribute (and pay taxes on) the majority of their account balance by the time they pass away. Therefore, RMD amounts can be well above $100,000 per year.
Individual: Joe Davis
Total IRA balance: $1.6 million
RMD (approx.): $82,000
Individual: Sarah Smith
Total IRA balance: $2.1 million
RMD (approx.): $194,000
Those RMD amounts are significant and will be treated, from a tax perspective, as ordinary income. In other words, according to the IRS, Sarah Smith at age 91 years old, just made $194,000 of income. Sarah may have never made $194,000 in a single year while she was working. Therefore, her tax bracket NOW could be HIGHER than when she was working.
Another way your post-retirement tax bracket could be higher than pre-retirement is if you deferred a significant amount of income.
So… what is the point?
First, it is not a “bad” thing to have high income in retirement or to be in a higher tax bracket post-retirement than pre-retirement. The problem comes when you are unaware of what you are doing to your long-term financial plan. So, the point is to make sure you understand how your present decisions are affecting your long-term situation.
CALL TO ACTION
The foundation of Signal Wealth’s planning process is to use your current, accurate financial data to project what could happen each future year for the rest of your life. Understanding the future as best we can, allows us and you to make better financial decisions now.
Are you tired of wondering if you are prepared for retirement? Are you tired of wondering if the financial decisions you are making now are optimal for you?
Improve your clarity. Take our Retirement Readiness Quiz and connect with an advisor. Talk soon!
This piece is designed to provide accurate and authoritative information on the subjects covered. It is not, however, intended to provide specific legal, tax, or other professional advice. For specific professional assistance, the services of an appropriate professional should be sought.
Distributions from traditional IRA’s and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59 ½, may be subject to an additional 10% IRS tax penalty.
A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.