By Nick Gertsema, CFP®, ChFC®, RICP®, AIF
While you are gainfully employed and building your nest egg, conventional wisdom says to save as much as you can and take advantage of tax deductions and deferrals. If you pay less in taxes, then you make more money, right? That may not always be the case.
Tax planning should be long-term. It’s easy to get short-sighted and try to figure out how to reduce your taxes in the current year or maximize your return. Unfortunately, that can sometimes come at the expense of long-term goals or may cost more in taxes down the road.
Tax-Deferred Doesn’t Mean Tax-Free
Roth 401(k)s and Roth IRAs are popular tax-free accounts. These accounts are funded with money that has already been taxed, meaning there’s no tax deduction when you make contributions. The money grows tax-free. Then, depending on the account type and if certain conditions are met, the money comes out tax-free. For example, money comes out of a Roth IRA tax-free if the account has been funded for more than five years and the account owner is over the age of 59½.
Some examples of popular tax-deferred accounts are traditional 401(k)s, traditional IRAs and tax-deferred annuities. Note that tax-deferred does not mean tax-free. Tax-deferred means taxes are still owed, but it’s a matter of who will pay them, how much they will pay and when those taxes will be paid.
Required Minimum Distributions
As you get older in retirement, you start to lose control of how little you take from certain tax-deferred accounts. In the year that you turn 72, the IRS starts to require that you take a minimum amount out of certain accounts or face a 50% tax penalty.
According to the IRS, the accounts that require minimum distributions are:
- Profit-sharing plans
- 401(k) plans
- 403(b) plans
- 457(b) plans
The RMD rules also apply to traditional IRAs and IRA-based plans such as SEPs, SARSEPs and SIMPLE IRAs. The RMD rules also apply to Roth 401(k) accounts. If you have a substantial portion of your savings in this type of account, this could mean that you will have more taxable income later in retirement than earlier in retirement.
Just because the money must be distributed from the account does not mean you must spend it. For example, you could take a distribution and put it in savings. A big question from a planning perspective is would you rather have that money available earlier in retirement or later?
Your Tax Bracket
We have an idea of what the tax code looks like this year, but what about future years? The cuts from the Tax Cuts and Jobs Act are set to sunset after 2025; what does that mean for your taxes?
If you and your spouse file your taxes jointly, there are some advantages. What would your tax situation look like if either you or your spouse were to pass away and the surviving spouse would then have to file as single?
Your Beneficiary’s Tax Bracket
Ideally, we won’t pass away until late in retirement. If that happened, how old would your beneficiaries be? There’s a good chance that if you’re planning on leaving a legacy for your children, they will be in their peak earnings years. If that were the case, how much of their inheritance would be owed in taxes because of the tax-deferred status? Remember, planning for tax-deferred accounts means we must decide who pays the taxes and when they are paid.
What Can You Do?
You don’t need to wait until you are retired to do tax planning, though it isn’t too late to consider it even if you’ve already retired.
If you are still saving for retirement, it may make sense to look at a long-term plan and see if putting too much in tax-deferred investments could create a potential issue down the road.
If you are already retired, it might make sense to look at your retirement income strategy and start taking some distributions earlier. For some, it may make sense to convert some of the tax-deferred investments to tax-free investments through strategies like Roth conversions.
Regardless of your life stage, a long-term strategic tax plan should be part of your retirement income plan. Not only could it help your tax bill, but it could also potentially help you create the confidence needed to be able to spend without guilt and live retirement the way you envision it.
We want to help you make life’s decisions on your terms – and not because the tax code says you have to. Contact us for a no-fee consultation.