Pre-tax retirement plans have been a favored vehicle of investors and financial advisors for many years. As a financial advisor, I have held the opinion that these plans are one of the, if not the, best way to save for retirement. Participants are able to conveniently and painlessly contribute to these plans through automatic payroll deduction and at the same time defer their tax burden. Over the last year or so, I have lost some of my enthusiasm for these vehicles. Let me explain why.
The traditional way of thinking with pre-tax retirement vehicles is as follows: While you are in your highest income earning years you make tax deductible contributions to these plans, thereby reducing your taxable income for that year and possibly your tax bracket. When you retire, your income and tax bracket will most likely be lower so you can take distributions from these accounts and pay taxes at a lower rate. Generally, in the year you turn 70 ½, you are required to begin taking minimum distributions from traditional IRAs and qualified plans. Based on current rules, if you still have funds in a pre-tax account when you pass away, your beneficiaries will likely (there are exceptions) be able (and required) to take distributions from these accounts over their lifetime thus spreading the tax burden out through the use of an inherited IRA (AKA beneficiary IRA).
I see two major problems with this plan. First, we are assuming that tax rates remain the same or decrease. In 2019, income tax rates are at close to historical lows. If your tax rate is higher in retirement than it was when you made the contribution, the traditional pre-tax plan will not be nearly as efficient. Second, and possibly more important, there has been a lot of talk about effectively eliminating the use of inherited IRAs for non-spouse beneficiaries. In fact, this has been a topic of conversation multiple times with legislators.
What would the elimination of inherited IRAs mean? If you pass away and leave a non-spouse (children, grandchildren, etc.) your traditional IRA or other pre-tax retirement account, they will likely have to take large enough withdrawals from the account to deplete it within a maximum of 5 years rather than over their lifetime. For example, if you have $2,000,000 in your pre-tax retirement account at death and have your 2 children listed as beneficiaries, they will each need to withdraw at least $200,000 per year (assuming no growth) for 5 years. An extra $200k in taxable income is likely to increase your children’s tax bracket significantly. So much for paying less taxes on these funds.
Please don’t misunderstand me, I still believe pre-tax retirement plans are a great way to save! But they should not be the only place you save. When planning for retirement, tax diversification is important. Just as diversification of your investment portfolio is important. Consider making contributions to your employer’s retirement plan on a pre-tax and, if available, on a Roth or other after-tax basis. You could also consider a direct investment in mutual funds, Roth IRAs, and life insurance cash value. Good financial planning and retirement planning is about putting the odds in your favor and tax diversification is a great way to do that.
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This article is written by Brandon Carter.