Defusing the IRA Tax Bomb
Your 401k/IRA is a great tax benefit right? You save funds now, get a tax deduction, and later when you take the funds out in retirement, you will be at a lower tax bracket – right?
What if the opposite were true – what if by putting off those distributions you were creating a TAX BOMB – an unexpected explosion of taxes? For some of our clients, this is exactly what they are facing. Knowing what you are facing later is an essential part of proper planning now.
Let’s review the rules and then look at examples:
KEY RULES
· Current year Traditional 401k/403b/SEP/IRA contributions are excluded from your Federal and state income tax in the contribution year. This is certainly a current-year tax benefit.
· These accounts can be accessed without penalty from age 59.5 on, and no distributions are required until you are 73 or 75 (see which date applies to you, below). No taxes are paid on gain during the years these accounts grow.
· BUT – when you do take funds out of a Traditional 401k/SEP/IRA – you WILL pay taxes – at whatever your rates are that year.
· RMDs – Required Minimum Distributions – are annual withdrawal amounts that RISE throughout your older years, starting at about 4% when you are in your mid-70s, to about 10% in your mid-90s.
· ROTH IRA/401ks are NOT subject to taxes on withdrawal (and also are not tax-deductible at the beginning). They grow tax-free until funds are taken out.
EXAMPLES
Where tax deferral helps:
Susan is retiring from her RN position at the hospital at 66, where she earns $85,000. She has been saving into her employer plans over the years and has $480k saved. She has turned her basement into a rentable apartment, and will bring in a renter this year. She plans to put off Social Security until 70. As we make her plan, we calculate that she will need $4000/month for 4 years until Social Security starts, at which point her IRA will be about $375,000. At that point we will begin a 4% withdrawal of about $1250/mo to supplement her $3500/month Social Security. Overall we expect her income to be about $48-60,000/year throughout retirement, and her taxes to stay relatively level over her retirement.
Did tax deferral help Susan? Almost certainly. In 2024, the $10,000 she put into her 401k would have been taxed at 22%. When she withdraws funds in retirement, most of her income will fall into the 12% bracket, at least as long as tax brackets and rates are similar. She may have part of it taxed at 22%, but mostly can expect to pay a lower rate on these withdrawals - Susan really experienced that putting off taxes to retirement would LOWER her lifetime taxes paid.
Where tax deferral hurts:
Chris and Pat are looking to retire at 62 each, one year apart. They are both Federal employees, have been earning $350,000 jointly, and have 25 and 32 years of service. Chris has significant assets from an IPO she was part of back in the 90s. They have both saved the max into their Thrift Savings Plan at work, and have enjoyed good earnings. Current assets = $1.6M Chris stock, $2.3M in their 2 TSPs, and they will have pensions of 50k and 60k.
Their thinking is to live off of Chris’ stocks for 8 years, postponing Social Security until 70. Then they would live off SS and pensions until 75 when they have to take required minimum distributions. They feel very happy they can afford to postpone their TSP withdrawals until age 75.
But what will their income look like at ages 75/76?
2 pensions (with COL increases) $160,000
2 Social Securities $170,000
TSP RMDs $220,000
Total Income $550,000!
Their TSP contributions would probably have enjoyed a deduction at the 24% tax bracket, and yet there is a good chance that their tax bracket will be HIGHER (likely 32% or 35%) once RMDs kick in at age 75. And if tax rates have gone up, the increase could be even higher. They did not get the same advantage of putting off taxes that Susan did – in fact, maybe it worked against them!
Yes your retirement plan can become a TAX BOMB!
PREVENTING THE TAX BOMB
How could Chris and Pat prevented this problem years ago?
Prevention strategy – Diversify the tax structure of your future savings! You have 3 choices about the tax structure of your future savings, and in the perfect world our clients are utilizing all 3 strategies over the decades of saving for the future:
· Tax-deferred (traditional IRA, 401k, SEP, etc) – pre-tax money goes into these accounts, and all taxes are paid at the end, when funds are removed from the accounts.
· Tax-free – Roth retirement accounts like Roth IRA, 401k, SEP etc – after-tax money goes into these accounts and they grow tax-free, and all withdrawals are tax-free
· Taxable – non-retirement accounts (joint, individual or Trust-owned) - after-tax money goes into these accounts, and there is a mix of some tax effect each year (dividends, interest, and realized capital gains) and postponed tax effect (unrealized capital gains). Capital gains and some dividends are taxed at a lower rate.
DEFUSING THE TAX BOMB
How would we help Chris and Pat NOW with their tax-deferral tax bomb?
Strategy 1 – Spend IRAs early – Chris and Pat could choose to SPEND their TSPs early – Taking about $120,000/year right from the start to supplement their Pensions will prevent the TSPs from growing. That way, they can continue that income right straight through, and their RMDs wouldn’t be so large. This should keep their taxes roughly level throughout retirement.
Strategy 2 – Roth Conversions – Chris and Pat could decide to convert $120,000/year from their TSP to Roth IRAs, and use their stock assets for lifestyle and taxes. This would give them the most protection from a future increase in tax rates, and the most tax advantages for their children when they inherit. They would go into their 70s with a large block in Roth IRAs that won’t have RMDs and won’t be subject to future taxes.
What’s the best strategy for Chris and Pat? It would depend on their goals and preferences, but either of those fixes for “Defusing the Tax Bomb” would help a great deal, and bring down their overall lifetime taxes.
Toler Financial Group uses financial modeling to look ahead at each client’s future and determine whether tax deferral is working for or against them. What is your plan?
** Age 73 RMDs start if your birth year is 1959 or earlier
Age 75 RMDs start if your birth year is 1960 or later
FAQS
Will tax deferral help in my 401k? Possibly! The variables that will determine this include - your income now, your income in retirement, tax brackets and laws, Required Minimum Distributions, account balances and sources of retirement income. Whew! That’s a lot, and having a financial advisor to help you sort this out might be necessary
Should I do Roth conversions in retirement? This also has many variables to help us decide - your income in retirement, tax brackets and laws, available funds to pay the taxes, your age, your pension and social security income, and what your RMDs will be like in the future.
“The following scenarios are for illustrative purposes only and do not represent the performance or experience of any actual client. Your results may vary based on your individual circumstances and assumptions used.”
“This discussion is for educational purposes only. Please consult your tax advisor before implementing any tax-related strategy.”