Tax-deferred accounts could lead to an unwelcome retirement surprise, so start planning now to tame the beast.
Plenty of retirements these days are built in large part by stashing away money week by week into tax-deferred accounts, such as traditional IRAs or 401(k)s, among other options.
And certainly, such accounts can provide a wonderful feeling of confidence, as well as a sense of anticipation, as you watch your money grow and count down the years until retirement.
But be warned: There could be an unwelcome surprise at the end of your retirement-planning rainbow. Donât forget that âdeferredâ is the key word in the phrase âtax-deferred account.â You didnât pay any income tax on the money you deposited in those accounts over the years, so rest assured that when you start drawing the money out to live on in retirement, you will be required to pay taxes on money withdrawn.
In fact, the government is so determined to get those taxes you delayed paying that when you reach 70Âœ youâre required to withdraw a minimum amount â called required minimum distributions, or RMDs â whether you need to or not, and whether you want to or not.
For so many people, the federal income tax in that scenario is a sleeping bear; it wakes up when we get into our 70s, and it growls loudly. At many of the workshops I conduct, people ask about the best ways to deal with this lurking tax menace. Here are some tips:
Many people contribute to retirement accounts through a 401(k) with their employers. Those are tax-deferred accounts, but these days, some companies offer a Roth 401(k) option. With a Roth account, you arenât deferring your taxes, which means you can withdraw the money tax free in retirement. For most people, the Roth option is the way to go.
If you donât have a Roth option at work, you might want to consider opening a Roth IRA âat home,â or a non-retirement account that would still let you save money but would give you a more favorable tax treatment.
Instead of waiting until retirement, now may be a good time to move your money out of those tax-deferred accounts and into something that wonât be taxed when you do retire. Sure, youâll pay taxes as you make that conversion, but thereâs a good reason to pay the taxes now rather than later. The federal income tax changes that took effect in 2018 are set to expire after 2025, so you have a short window of opportunity to make these conversions at a lower tax rate.
You might say: âBut what if they extend the tax cuts?â Not likely. It took Congress 31 years to pass the Tax Cuts & Jobs Act of 2017. Also, with the changeover in U.S. House leadership, Washington is no longer a friendly environment for tax cuts past 2025.
Some things to keep in mind when considering a Roth conversion:
Tax-free municipal bonds are issued by your state, or a unit of government within your state. Youâre lending money to your state government, or your county, your town, etc. When purchased from your state, or within your state, the income you receive is âtriple tax-freeâ (free of federal, state and local taxes).
Three concerns: As interest rates rise, the market value of your bonds falls, so this may be a risky option, should the Fed raise rates. And, if you live in a state where the governmentâs finances may not be on solid footing, you could lose the value of your bonds in the case of a bankruptcy (e.g., Detroitâs 2013 bankruptcy). Also, tax-free interest is one consideration the IRS uses to calculate how much federal income tax you pay on your Social Security benefits.
Considering these three concerns, I would steer clear of this option.
An indexed universal life policy is a type of permanent life insurance. With IUL, you donât lose money in a market downturn, but you can lock in annual gains tied to a market index. This can work even better than a Roth conversion for a number of reasons.
First, you get protection from a market downturn. Second, thereâs an income tax-free death benefit in excess of the balance of your cash value account. Third, you can participate in the good years of the stock market through indexing, locking in your gains annually, so that you never give those gains back in a market correction. Fourth, you may be able to accelerate the death benefit to help pay for the costs of long-term care if you need it. Some policies offer a long-term care rider. However, in many cases these riders arenât truly necessary, as you could just use tax-free policy loans to access the money needed to help pay-for your long-term care. Fifth, life insurance doesnât generate RMDs, or any taxes on income through the use of policy loans, which keeps the IRS from further taxing your Social Security benefits.
It’s important to remember that most life insurance policies are subject to medical underwriting, and in some cases, financial underwriting, and the costs of a life insurance policy, including premiums and cost of insurance charges, are dependent on your age and health at the time of application. We walk through these details with each client, and help them to make the decision as to whether or not this approach makes sense in their overall tax-planning.
Thereâs also another factor in all this that you shouldnât overlook: your family and your legacy. When we die, most of us hope to leave something behind for our loved ones, but the worst thing to leave your heirs is a tax-deferred account, like a 401(k) or IRA. They would actually have to pay income taxes on it. We can leave behind tax-differed money, or tax-free money. Which would you rather leave your heirs?
For example, if you leave a traditional IRA to your kids, they are forced to take the RMDs â the required minimum distributions â and the additional taxable income can move them up in tax bracket.
If your retirement plan has been built largely with deferred-tax accounts, now is the time to start contemplating a tax-efficient conversion to tax-free keep more money for you, and less for Uncle Sam, in your golden years.
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Dan Dunkin contributed to this article.
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