Is Your IRA a Tax Nightmare?
For many Americans, putting money back into a retirement account such as a 401(k) or traditional IRA has been their primary choice to save for retirement. After all, most company plans offer some sort of matching incentive based on what you contribute and your contributions are deducted from your taxable income. In fact, you may not have been able to find the money to save at all if it weren’t for the tax deductions created by your contributions.
The problem with this is: The IRS is going tax you…either coming or going.
If you take a deduction when you make the contribution, then you will pay taxes when you take a distribution down the road. You also don’t pay tax as your retirement account grows. This taxation is deferred until you take your distribution. Ultimately you could pay tax on every dollar distributed out of your retirement account.
You may be thinking…that is the biggest scam ever! The truth is that it depends.
Generally speaking, most retirees claim less income on their tax returns during retirement years. Couple this with the fact that we are in a progressive tax system, and this could mean that the tax on your IRA distributions really won’t be a huge factor on your overall taxes.
The problem is that times are changing…and so is the average retirement.
1. We are seeing more and more retirees wanting to spend just as much money as they did in their working years - or often times even more during their early years of retirement.
2. There is a lack of diversification as to where retirement income is derived. Pensions have disappeared from much of the private sector, so this leaves Social Security, retirement accounts, and other savings or investments. And unfortunately, too many Americans are not saving much outside their retirement accounts.
Why is this important?
Let’s assume that you have 99% of your retirement resources in a retirement account and have a big project like a home remodel or a series of emergencies is forcing you to take additional distributions from your retirement accounts. If these funds are all in retirement accounts, it means they will be taxable. And remember, we are in a progressive tax system. What if this additional distribution bumps you up into a higher tax bracket? And what if this distribution also increases the amount of Social Security that is taxed to you? And what if this additional distribution also increases your Medicare premium? And if that isn’t bad enough - don’t forget you’ll have to pay tax on the money you withdrew to pay the tax!
3. The Tax Cuts and Jobs Act of 2017 is scheduled to sunset in 2026. This could mean your retirement just got more expensive due to the reversion of tax brackets to pre-2018 levels.
4. Where do you see taxes going if our nation’s debt is at an all-time high and continues climbing?
5. Even if you don’t count on your retirement accounts for retirement, taxes could be inevitable and they could hit hard!
What? Let’s assume you pass away and leave your IRA to your son or daughter. Historically, he or she would have been able to take what is called a Required Minimum Distribution (RMD) based on his or her life expectancy. This would essentially allow your son or daughter to stretch the distributions and potential tax over a lifetime. Not anymore. The best-case scenario today is that he or she would have to take out the full account balance within 10 years and pay any tax owed. This could be extremely painful for a million dollar plus IRA. This is also not to mention – again – that we are in a progressive tax system. What income tax rate would he or she be looking at, especially if your child is already successful?
None of this is to say that contributing to a traditional retirement account of some sort should not happen. There are many cases in which it does make sense. For example, are you going to pass up 100% return on your money with a company match if your only availability is that traditional plan? Or what if your taxes are at the highest level now? There are many times that it would make sense in this case. And, of course, if this is the only way you can afford to save money for retirement, then you certainly may want to use a traditional retirement account.
Retirement planning and tax planning are complicated to say the least. Which is why we have a job. And your job is to have a plan, because no plan actually is a plan and could be your biggest nightmare. If you have questions, give us a call.