
Is Your Retirement Plan (401(k), 403(b), 457, etc.) Creating A Tax Problem?
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, ways 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 couple of years, 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 73 (or 75 in the year 2033 or later), you are required to begin taking minimum distributions from traditional IRAs and qualified plans. Based on prior 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. Since these accounts are tax-deferred taxes, they are due only when withdrawals are taken. By taking smaller withdrawals each year based on their life expectancy, a beneficiary spreads out (and often reduces) their tax burden. This was commonly referred to as a “stretch IRA”
I see two major problems with this plan. First, we are assuming that tax rates remain the same or decrease. In 2024, 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 more importantly, the Secure Act and Secure 2.0 significantly changed how pre-tax IRA and qualified accounts received by non-spouse beneficiaries are treated. While spousal beneficiaries still have the ability to take over an IRA, they inherit it in their own name and even combine it with IRAs they already own. Thereby continuing to defer the taxation on these accounts if they choose to. Non-spouse beneficiaries, in most instances, are no longer able to stretch the required distribution out over their lifetime. They are now forced to deplete the IRA or qualified account they are inheriting within ten years. No more “Stretch IRAs” for non-spouse beneficiaries!
What does this mean? Let’s look at an example, if you have $2,000,000 in your pre-tax retirement account at death and have your one child listed as beneficiary, they will need to withdraw the entire $2,000,000 plus any earnings by the end of the 10th year following your death. As you can imagine, this will probably bump them into a higher tax bracket for several years. If your beneficiary is already making a good income (already in a higher tax bracket), their inheritance will be taxed at an even higher rate. This situation further reduces the benefits of pre-tax retirement accounts.
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 very 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.
View more related content below:
https://fsgmichigan.com/vlog/why-paying-more-taxes-today-may-be-a-good-idea
https://fsgmichigan.com/vlog/true-finance-consolidate-to-simplify
https://fsgmichigan.com/blog/the-new-age-of-financial-responsibility
https://fsgmichigan.com/blog/how-do-i-find-the-right-financial-advisor
Written by: Brandon Carter
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