They say it’s not what you earn, it’s what you keep. I agree with this wholeheartedly as it relates to not spending more than you make. However, in my line of work, being sensitive to the TAX efficiency of a retirement plan is critical. If I can save my clients $10,000 or even $20,000/year in taxes during retirement, that’s huge! It’s rewarding watching them spend it on bucket list lifestyle events such as travel or gifting. When working with new clients, I’m often informed about the same scenario, which is previous advisors who did not address tax concerns they should have years, if not decades ago.
Whether I am working with a younger family in their 30’s or 40’s, those in their late 50’s or early 60’s at the brink of retirement, or even clients that are taking Required Minimum Distributions in their 70’s or 80’s, there are always ways we can be sensitive to taxes. I want to address one of the biggest tax traps my clients that are retired face, and how to avoid them well before your retirement.
So what is the “Tax Trap?”
It’s saving too much into your Traditional 401k or Traditional 403b plan! You might ask, “I thought you might advocate maxing our retirement savings plan options?” My response, “Of COURSE I do.” However, let me be clear, when I say “Traditional 401k/IRA,” I mean those funded with pre-tax dollars. This results in the growth being tax deferred. Today, many employers are offering both ROTH 401k and ROTH 403b plan options. These accounts allow savings on an after tax basis and the benefits of tax free growth.
My tax savvy folks then say to me, “Don’t you advocate for maximizing tax deductions today?” My favorite response, “it depends.”
Over the last 12 years, I have had the privilege of working with some amazing clients. These folks range all over the wealth spectrum, but in general I would say my clients are fairly well off and well positioned for retirement. In addition, these folks typically between 20-40 years maximizing these pre-tax 401k or 403b plans (Roth 401k/403b plans are fairly new). As a result, they have a sizeable nest egg, much of which is in the tax deferred bucket. That bucket, once you turn 72, is forced to be drawn upon based on the IRS life expectancy tables, regardless if you really need it for income. Many argue that taxable income is going to be lower in retirement than before retirement. For some, this may be true. However, once you add Social Security Income, Investment Income, Pension, Part time/consulting income, and lastly that Required Minimum Distribution that kicks in at age 72, many of my clients are earning the same, if not more, in Retirement than they were previously. Furthermore, those “RMDs,” are often times surplus income that is not even needed at that time! The result they are being forced to spend down their 401k plan or IRA just because the IRS has strict penalties (up to 50% of the RMD amount) if not done correctly!
I don’t want to get into an argument of higher taxes versus lower taxes in the future. However, I generally believe taxes are likely to go up given the government liabilities we face, and with the COVID relief stimulus, but only time will tell. After crunching the numbers, I have a strong belief that utilizing ROTH 401ks/403bs and ROTH IRA’s are a great way to offset this Tax Trap. If nothing else, it allows you to be strategic based on the tax environment in that given year.
Let’s say we have a period of higher tax rates in your retirement years. During these years, it’s advantageous to have an option to withdrawal funds “TAX FREE.” The only way to do this is to have some dollars in the tax free bucket, such as ROTH accounts or other assets that are a bit more complex. Let’s then say a new administration comes in and is slashing taxes dramatically. In that scenario, you might be willing to spend down those “taxable” accounts given the lower tax bill! We cannot be strategic if you don’t have the diversification of taxes on your balance sheet.
THE SECURE ACT
I now want to address another major issue that relates to the SECURE Act. I will be doing a podcast where I will also expand on the planning issues that have surfaced, but here is the short version. The SECURE act stands for “Setting Every Community Up for Retirement Enhancement” Act. There are some pretty nice features in this piece of legislation. Some of these include the following: making it easier for small businesses to get retirement plans more cost effectively, enhancing diversification in these retirement plans for the benefit of participants, changing the Required Minimum Distribution age from 70.5 to age 72, and even allowing for some tax free withdrawals on 529 plans to repay certain student loans. All in all, it seems to be pretty positive.
In order to pay for this, it will require tens of billions of dollars (estimated) in additional tax payer funding. Where is the IRS going to get this funding? You guessed it, your tax deferred IRA/401k/403b plans that you worked so hard to accumulate over your career.
The Elimination of the “Stretch-IRA”
Pre-SECURE Act, if you were to leave that IRA/401k/403b to your children/grandchildren or any non spouse, they could take withdrawals based on their life expectancy, and in essence “stretch” that IRA out for a long time and thus reduce the annual tax burden. Not anymore. The stretch IRA provision was eliminated, and those non-spousal beneficiaries will be forced to draw down that retirement vehicle within 10 years, thus increasing that tax revenue to pay for the SECURE Act.
Now to some people, they may not care. They may say, “my kids can deal with it, I’ll be dead.” However, if you truly ask those same clients, would you rather give the IRS more or less money than you need to? 100% of them don’t say “more.” One thing I hear often times is that my clients children make way more than they ever did during their working years. As a result, those beneficiaries may already be in higher tax brackets. If you add on top of that the burden of the “10-year spend down” provision in the SECURE Act, it might lead to some unhappy children and a hefty tax bill to Uncle Sam.
Now, there are many solutions to this, which I won’t get into here. I believe the takeaways from this new rule are:
- Be tax diversified, because laws are guaranteed to change many times over a lifetime!
- Leverage ROTH/tax free money when all other variables are equal
- Think about your Estate Planning strategies. What assets make sense to pass to children outright? Should you change the taxation of your IRA during your lifetime before you pass those assets to the next generation?
I am always happy to field questions or concerns about these issues, or others. If you want to schedule a time to chat about your personal situation, you can either click this link to my calendar availability: https://calendly.com/imaginefs/30min, or you can email me at Kevin@imaginefinancialsecurity.com
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Also, check out the Podcast where I will go over some planning strategies to offset the SECURE Act tax burden and help you better plan for your Retirement and Estate Plan. https://imaginefinancialsecurity.com/podcast/