In the last few posts, I have been discussing the five risks to your retirement, which include inflation, market risk, loss of control, and income depletion. The last risk, taxes, have the biggest impact on your retirement but is one that many people don’t realize is affecting their retirement as much as it is.
First, consider that you have the ability to defer taxes by depositing money into a 401(k) or similar account. If you were fortunate to accumulate $320,000 at retirement, you will have to subtract taxes on that amount at the time you start to withdraw. When people are sold the idea of contributing to a 401(k), the deferred taxes benefit is always what is touted, extolling the virtues of not having to pay taxes now, but later in retirement, when supposedly you will be in a “lower tax bracket” (big misnomer here).
To understand what this tax burden really looks like, let’s use the analogy of a farmer planting a crop. When a farmer plants seeds, they multiply and grow and eventually produce a crop, which is worth many times more in value and volume than the original seed. A 401(k) fund is like the crop: you pay taxes on the end result or the harvest, meaning you pay taxes on everything you contributed, everything your employer contributed, and all the interest that fund has earned over the your lifetime. But if you had your money in a tax-free annuity or a Roth IRA for example, you would pay the taxes up front, on the seed so to speak, and not on the larger amount later in retirement. So the question is, “Do you want to pay tax on the seed, or on the crop?” The answer is obvious, yet so many would rather put off paying taxes now and pay more money later than look at other alternatives that will keep their tax burden down.
Okay, now let’s suppose you retire and shortly after that you die. Using the spousal rollover, no tax is due until the second spouse dies. Then the remaining amount of money goes to the children. They appreciate the money, but now they have to pay a much higher tax as they add this inheritance to their earned income. Therefore, the counsel to invest aggressively in a 401(k) or IRA because you’ll supposedly be in a lower tax bracket at retirement is WRONG! Go to any CPA and ask what amount of tax their retired clients pay on their income. They will tell you the amount is huge because they no longer have dependents, interest deductions on their paid off house, etc. No deductions equals higher taxes!
Why doesn’t anyone tell people that taxes will be the biggest draw-down of all during retirement? At retirement you don’t have the benefit of many deductions, but you always have market risk, inflation, and the threat of outliving your money to deal with, plus taxes are going higher all the time. And don’t forget that you must now pay tax on a portion of your Social Security income as well. I have found that more tax is paid after retirement than before on most clients I have worked with.
You must consider these chain of events:
- When you get to retirement and have an amount of money accumulated, say $320,000, you think you can live on $40,000 a year.
- You decide to pull out the $40,000 from your 401(k) but then realize you will be out of money in eight years if you continue to do this.
- You don’t plan to be dead in eight years and start to worry about outliving your money. Plus you realize you now have to include your Social Security benefits as you prepare your taxes because 401(k) income forces Social Security to be included for tax purposes. This averages around $5,000 per year in taxes!
Here is another tax concern. At 70.5 years of age, you must start taking out your deferred taxable income or pay a 50 percent penalty and ordinary tax on that portion. The IRS can’t just keep waiting to receive your deferred taxes, after all, they want to be paid, so you are forced to withdraw whether you like it or not.
There are better options than just dumping all your money in a tax-deferred retirement account. Contact me today for a no obligation consultation: firstname.lastname@example.org.