The 401k IRA Tax Trap
The Tax Trap of Traditional 401ks and IRAs
Kevin Lao 00:12
What’s going on everybody? This is the Planning for Retirement Podcast. My name is Kevin Lao and I am your host.
What is the tax trap?
So today’s topics are twofold. The first thing I wanted to address is; what I like to call the Tax Trap of 401ks and Traditional IRAs. So I don’t think people address this enough prior to them retiring. And this is the notion of being tax efficient prior to getting into retirement and control it on acquisition. So having seen this go down for years and years and years being in business, I thought it’d be beneficial to do an episode specifically relates to falling into that tax trap and how to avoid it well before you turn retirement age. So that would be number one.
The SECURE Act
Number two is the Secure Act. And for those of you that don’t know, the Secure Act was legislation that was passed to reform retirement. And I don’t think many people really understand the ramifications of the Secure Act. It was largely swept under the rug obviously for good reasons because of Coronavirus in 2020 so it did not get much publicity after March of 2020. So, I thought I’d be good to revisit this topic because it is going to drastically change the way retirement [unintelligible 01:32] for future generations. And for those of you that are retirement age that are thinking about leaving your retirement account 401k IRA [unintelligible 01:42] children or grandchildren, you need to hear what I have to say.
For those of you that are younger, let’s say you’re in your 30s, 40s and 50s and your parents or grandparents are retirement age, and they plan on leaving a 401k or IRA to you, you should also understand the ramifications because this could absolutely screw up your tax situation.
So these are the topics we’re going to address today. And I’m also going to talk about some strategies to offset some of these concerns that my clients are putting into play and hopefully it’s beneficial for everybody. Let’s dive in!!
How does the tax trap occur?
All right so why our traditional 401k’s and traditional IRAs, why do they lead to a tax trap at retirement. So I want to clarify something when I am referring to a traditional 401 K and IRA plan I am referring to those that are flooded with before tax dollars. And what that leads to is tax deferral in those plans and then when you go to make those withdrawals in retirement, then they are taxed at ordinary income rates, whatever they might be in the future and that is the key.
When you think about taxation now relative to where they might be in the future. I’m not going to make a bold prediction here because I think a lot of people feel the same way I do. I’m going to suggest that taxes are likely to be higher in the future than they are today.
And if you think about, right now, we are at a $27 trillion deficits in the US, and that’s not shrinking. It’s growing. And you think about some of the government liabilities that are not funded like Social Security, Medicare, Medic-aid, you think about in 2008 we had massive bailouts and then in 2020 and likely in 2021, we add more bailouts. And you know, that causes concern for someone who is, let’s say, 15, 20, 30 years out from retirement age because if you are deferring taxes at potentially lower rate today, and you’re enjoying market growth for the next 10, 15, 20, 30 years, you’re growing this massive tax liability that Uncle Sam it’s just licking his chops. So therein lies the tax trap. And, you know, again, I refer to these that are funded by pretax dollars I’m not saying 401ks are bad because frankly 401ks are a great thing. You know they are forced savings plans that employers offer. They oftentimes give you matching contributions, essentially free money. So absolutely take advantage of this programs for your employer, do the max contribution possible.
Diversify your tax buckets!
But what I want you to think about is how can you diversify your tax situation.
So if taxes are higher in the future, you’re not stuck with only one pocket drop. And one of the ways to do this and think about this is looking at Roth 401ks and Roth IRAs. So literally the opposite of a traditional 401k or IRA plan these are funded with after tax dollars, and these enjoy tax free growth. So regardless of what tax rates are in the future, it does not matter. You’ve already paid taxes on the contributions and as it stands right now, the IRAs code allows you to withdraw those funds as long as it’s for qualified purposes, i.e. retirement, they can be withdrawn tax free so you know, when I’m planning with clients, I am all about tax diversification, I’m all about being strategic and I understand that, you know, we can’t predict the future. We don’t know exactly what tax rates are going to be in 5, 10, 15, 20 years throughout their retirement years. But if we have diversification we can be strategic based on who is in office essentially. Because one thing is guaranteed regardless of whose administration we’re going to try to change taxes. They might raise taxes and might slash taxes and might raise taxes for some, slash taxes for others. So regardless of what they do if we have some money in tax deferred and some money tax free, then we can be strategic. So for periods of times and very high taxes, and we don’t want to touch your tax deferred programs we can draw from tax rates.
If we’re appear [phonetic] to have time of very low taxes, you might be more okay with drawing your taxable funds. And so you can’t do that if you don’t have diversification. So I think the takeaway here is when you’re contributing to these retirement plans, be strategic and consultant with advisor, a tax advisor, a fiduciary financial planner, they can point you in the right direction to see what your options are in your plan. And also, hopefully they understand your situation that can give you the best guidance possible for you to make the right decision for yourself.
Required Minimum Distributions (RMDs)
Again, don’t fall into the tax trap because what it leads to is, folks when it gets to retirement is a lot of surprise and I’ll give you an example. Required Minimum Distributions kicked in at age 72 and at age 72 now the rule is you have to take out a certain percentage every single year for the duration of your life expectancy.
And right now the IRAs tables they are kind of outdated I would anticipate them updating these at some point in the not so distant future. But every year that percentage that you are forced to withdraw goes up and up and up. And so income from Social Security or let’s say you’re consulting or working part time, or maybe you have some investment income, and maybe even need this income from your 401 K plan or IRA. Well the IRAs as it stated right now at age 72. You’re forced to take those withdrawals whether you need it for income or not. And again, this leads to a tax situation where you know, let’s say you have a $2 million 401k plan and let’s say your percent that you’re forced to withdraw in the given years, let’s say 5%. Well, that’s $100,000 that you have to add to your taxable income if that is a traditional 401k or IRA plan that you may or may not be and the result is it might push you into a higher tax bracket, it might actually put you into a different Medicare [unintelligible 08:02] premium which I should pay more Medicare costs. So there’s a lot of ramifications that people really think about before they get to their retirement age so I urge you to plan early and often, think about taxes. Well before you get to retirement age so you can get smart and strategic when you’re going to make those withdrawals.
SECURE Act, explained
All right, let’s talk about the Secure Act. So the Secure Act, it stands for setting every community up for retirement enhancement act. And in my opinion, this is probably the most substantial overall when it comes to retirement, planning, since I have been in a business 2008. There’s a lot of good to it, it’s made it more cost effective for small businesses to offer retirement plan, it allows lot of these small companies to join together essentially as a union and get discounted rates [phonetic 08:59] because then these providers look at them as one entity as opposed to several sets. So that’s a positive.
It also increased Required Minimum Distribution age from 70 and a half to 72. So just a little bit more time to deferred Required Minimum Distribution age until they are forced to draw upon them. It allows penalty free withdrawals upto $10,000 for 529 plans to repay student loans. So if you get 529 plan or you have one set up for your children or let’s say someone set up 529 plan for you that you never just use in college you can use those up to $10,000 to repay student loans, so that is nice. It’s a little bit more diversification when it comes to retirement plans, etc., etc. And there are some other things as well. So there’s a lot of positive because in order to pay for it, this is estimated this cost was legislations estimated 10s of billions of dollars and the way they are going to pay for this is by eliminating the stretch IRA essentially allows for a non-spouse [phonetic 10:15]. Let’s say a child, an initial owner of an IRA or 401k plan who passes away that allows for them to withdraw those distributions [unintelligible 10:28].
Now that’s a big deal because we talked a little bit about Required Minimum Distributions a moment ago where someone with 2 million dollars maybe force [phonetic 10:36] to take a 5 percent. Well, I’m going to give you another example, who is 90 years old, they are forced to take out roughly 8.27% per year for that year from their retirement account. Let’s say they were to pass away, pre Secure Act and they were to leave those dollars to someone who’s let’s say, 55 year old. Well, for the 55 year old son or daughter instead of having to take out 8.27% of the account they are only required based on their life expectancy to take out 3.38% of the o they got tax savings. I mean that is that is more than 50% of what they would essentially have to pay if their parents unintelligible 11:28] drawn retirement account, so in essence allows that non spouse beneficiary in this case in child to stretch out this tax deferral stretch out that retirement throughout their life expectancy, well, as secure act very fine. They eliminated the stretch IRA and essentially it forces these non-spousal beneficiaries and there are some exceptions so please consult with your tax advisor, your attorney, your financial planner, to understand the Secure Act there are some exceptions, but in general common beneficiary like a child or grandchild, they will be forced to withdraw all of the proceeds of that account within 10 years. It doesn’t matter the schedule, they can take it all out in year one, which would be a really big tax bill. They take it out and they can spread it out over 10 years. The IRS doesn’t really. They just want to make sure that all of the money is out of that retirement account.
The inherited IRA rule changes
So why is this significant? Well, instead of that 55 year old beneficiary taking out 3.38% that year given their life expectancy, and let’s say that account is a million dollars that is roughly 33,000 that would have to take out. Let’s say they were had to have that same [phonetic 12:44] million dollar account inherited and let’s say they want to spread out that tax burden evenly across 10 years. Well, if you look at simple math, they would have to take out $100. So instead of recognizing 33,000 as income, now they’re recognizing 100,000 income. Now obviously, as the account grows, let’s say it’s 2 million, 3 million the tax burden become bigger and bigger. And what I hear from a lot of my clients who have children that are in the 30s and 40s and 50s is that may make way more than my clients ever did during the working years and I think that is just the byproduct of the United States being a great nation, wealthy nation. But many times the children and grandchildren are much better off financially from an income standpoint as they are predecessor and so why that’s so important because they may already be in very high tax. And they may be in a really complex situation, they may live in a state with high taxes i.e. California.
So if you are leaving those retirement accounts to one of those types of beneficiaries, it could seriously impact the taxation of those accounts. And I am having this conversation left and right every single with clients that have retirement accounts that they saved into 20, 30, 40 years. They worked in extremely [unintelligible 14:04] And now they are in the situation with 70 or 75 or even 80 years old, and there’s not much you can do, you know, other than some small planning, you know conversions, which we’ll talk about in a second, but there’s not a whole lot you can do to alleviate that tax.
So there’s a conversation that you have to be had with your advisors, your financial advisors mistake, you got to make sure that you’re not going to screw over the next generation because I’ve never heard any of my clients say they want to give the IRAs more money than they have to. And you know this is the perfect example and this provision was slipped in and a lot of people don’t understand it. And so please be aware of how this will impact your situation and I am happy to have this conversation with you. If you have questions by your personal situation then you can email me on my website at www.imaginefinancialsecurity.com.
I’m happy to dive into the details of your situation to see how this impacts you and your beneficiaries.
All right, so with all that being said, why don’t we break down three different strategies that my clients are putting into play in light of some of these tax concerns in the future? And also with the secure act now fully in play as of 2020 and I’m going to categorize them into beginner, intermediate and advanced.
How to avoid the tax trap of 401ks and IRAs?
Beginner I would put into play for someone who is younger, maybe they have at least 5, 10 or 15, better yet 20 more years of working and accumulating retirement accounts. And simply looking at the idea of instead of maximizing all of their contributions before tax, looking at Roth 401ks and Roth 403 B plans or even Roth IRAs, and we’re checking with your HR department and seeing if those plans are available, these after tax plans. And if so deciding whether or not it makes sense for you to put these dollars in on the post-tax basis in [unintelligible 16:05] before tax. Now, you don’t have to go all in one way or the other. You know, I have a lot of clients that split contribution some do pretax, maybe 50% and then the other 50% after taxes into the Roth. You can do whatever you’d like and you know, the scenario where you may want to leverage more on the tax deferred side is a scenario where you live in a high tax state now and you plan to retire in a low or no income state tax… States* That was a lot.
So an example would be somebody’s working in New York and they plan to retire Florida, which is where I live now. And we have a lot of those types of clients and in those scenarios if they’re already a high income, and there’s obviously heavy state taxes there and they’re retiring in the next couple of years, maybe 3 or 4 or 5 years down the road. It may be beneficial to do some before tax or leverage a little bit more before tax and therefore once they retire and residents of Florida or Tennessee or any other state income free tax state then take distributions and pay the taxes.
Now, other folks who are again concerned about tax rates going up, they may just wanted leverage more on the tax free side of the Roth side. And, you know, obviously there are some restrictions, you know, some folks may not have the ability to use Roth 401 K or 403 B plan some plan don’t offer them for whatever reason, and other folks maybe phase out of Roth IRAs and there is an income limitation. But once you make a certain amount you can longer contribute to a Roth IRA directly.
You know, there are some loopholes around that which I’m not going to get into those types of tax planning strategies on this episode. But there are some loopholes, just search backdoor Roth IRA. That’s a way to contribute to a Roth even though you’re above that Roth hiring threshold, but again, you got to be careful with it. You need to make sure you’re aware of the aggregation rule that can really, really mess up on a tax standpoint. So please consult your tax advisers before you make any of those decisions and I’m not getting any tax advice here.
All right, so we’ve addressed beginner which is simply contributing more to the Roth side when you are working.
Intermediate; someone who has been working for a longer period of time, let’s say they’re in their 40s 50s or 60s they are approaching retirement sooner rather than someone that is in the 20s or 30s, they may have accumulated a decent size, next [unintelligible 18:41] a 401 K’s or IRAs already. Now these folks may benefit from doing what’s called Roth conversions. So a Roth conversion the way that works is you take dollars that are already in an IRA and you convert them pay the taxes now and convert them to a Roth to enjoy that tax free growth going forward.
Now, obviously the downside you have to have the cash to pay the taxes, the taxes can’t just come out of the account because you will be charged penalties presumable if you are younger than 59 year and a half. So you got to have some cash on hand to pay the tax but the benefit is you can get those dollars in growing tax free for the next 15, 20, 30 plus years and enjoy all of that tax free growth. And again, avoid those Required Minimum Distributions, that those are the type of plans have in place at age 72. Now this is a great tool that I have utilized a lot of clients in the past. You want to make sure that when you’re doing this that you’re not putting yourself into a tax un-favorable situation. So for example, someone who’s aged 65 and they are in Medicare and you’re doing Roth conversions. You may not want to put them in a threshold or a tax bracket or they are paying more Medicare costs. That’s something you want to be aware of. You may not want to push into different tax brackets so there is definitely a sweet spot for you. So you definitely want to make sure if you consult your advisors in terms of what is best for you and if this strategy makes sense.
But again, I’ve reviewed this many, many times with clients and for some it makes sense and for some it’s not. And you know it all depends on situation that is why you want to consult your advisor before making any decision. However, crunching the numbers and looking at the analysis long term for many of those clients where it makes sense, it could save not only them 1000s of dollars in taxes in retirement, but also their beneficiaries, you know, especially because in light of the Secure Act and stretch IRA elimination.
All right last category, the advanced. Now this one I would characterize for folks that have accumulated a pretty substantial network, maybe in retirement accounts, or combination of retirement accounts and elsewhere. And you’re looking at the notion of buying a life insurance policy to essentially pay those taxes that will be due upon their passing within those retirement accounts. Let’s say hypothetically someone has a $4 million IRA, and they plan it leaving it to their doctor. But $4 million will have to be liquidated within 10 years assuming they are not an exempt beneficiary.
So let’s say hypothetically, they wanted to withdraw those funds in equal installments over 10 years. So for simple math purposes 400 k dollar. So they would have to they would have to pay taxes on that $400,000 annually, you know, which I would have heard that they may do 100,000 or so plus or minus depending on with your tax situation is per year on taxes. So over the course of the next 10 years, they’re going to have to pay about a million dollars in taxes if you take 100,000 times 10 If you follow me. So the idea of buying life insurance is that the individual that wants to maximize these dollars to the beneficiaries versus the IRS, they decided by a permanent life insurance policy for a million dollars. And over the course of their lifetime they may pay a fraction of a million dollars in premiums for the benefit of those dollars, going tax free to that beneficiary and help alleviate that tax burden on there.
Now, there’s a lot of nuances involved. When it goes into buying permanent life insurance. There’s a lot of flavors, there is universal policy, hybrid policies. There’s joint and survivor policies, traditional whole life. So you want to make sure you’re consulting with some seasoned professionals when it comes to doing this. I always recommend coordinating with your financial planner, your insurance agent and even your estate planner to make sure that this strategy A makes sense and B that you’re designing the policy properly.
Given my background, I have an extensive background in insurance. This is a conversation I am very comfortable with having with our tax advisers and with my state attorneys clients. So if you have questions on this, don’t hesitate to reach out to directly on the website, www.imaginefinancialsecurity.com. So I hope that helps.
So the three areas; again, beginner, intermediate and advanced. I think that many people that are working can take advantage of Roth contributions very, very easily. In terms of the right percentage going where or how much you speak towards Roth, it’s going to depend on your situation personally. So again, please consult someone you trusts on this matter, Roth conversions or IRA conversions into rock.
Again, a great tool for some and for some it’s not a great tool. But again, it’s a way that you can add more dollars into that tax free bucket and protect it from that Secure Act tax penalty and also enjoy the tax free growth without the Required Minimum Distributions and advanced life insurance planning which again is a great tool assuming the client is healthy. That’s another nuance as well you have to be healthy and qualify for life insurance and many people that are in their 60s or 70s maybe they have in preexisting condition resistant condition or it’s just cost prohibitive. So again, there’s a lot of you know what if scenarios to see if that type of planning makes sense. But I hope you liked today’s episode. I hope you enjoyed it and I hope you subscribe to our podcast if you like it what will bring it to the table. You can do that by hitting the subscribe button to whatever platform you’re using, whether it’s Spotify, iTunes, etc. You can also just go to our website directly all over the podcast and blog post we are going to listed there on the in sites tab www.imaginefinancialsecurity.com. You can also contact me directly via email if you have specific questions that you want to address or if there is topics that you want me to bring to the table in these podcast. This is what this is for. I do this for fun because I’d like to talk about financial planning strategies and I like to help people regardless if they are client of mine or not. And I hope everybody enjoyed it. Look forward to next go run. Cheers!!