It is quite common to see investors who have saved for retirement in only tax-deferred accounts, either through their employer, such as a 401(k), qualified pension or stock bonus plans, qualified profit sharing plans or 457(b) or 403(b), or other retirement savings vehicles, such as traditional IRAs, SEP IRAs or SIMPLE IRAs. While these investors have diligently saved throughout their life, the same people become hesitant to spend their money in retirement. Surprisingly, these situations have nothing to do with a fear of running out of money. Instead, it has everything to do with not wanting to pay the taxes due on the tax-deferred growth.
The IRS has let your retirement assets grow tax-deferred throughout your lifetime. Ideally, by deferring the tax, your assets can grow faster, and you may be able to defer the income tax due to a time when you may be in a lower tax bracket than your earning years. The IRS has required minimum distribution (RMD) rules that require you to withdraw a specific amount annually once you reach age 70 ½. Failure to withdraw the minimum amount results in a federal penalty of 50% of the RMD not taken. The purpose of the RMD is to spread out the distribution of your account over your expected lifetime, and to ensure that investors do not just defer taxation indefinitely, leaving the funds as an inheritance and passing the tax liability to the heirs.
For investors who are adamantly opposed to paying taxes on their RMDs, there are options. If your assets are in a company-sponsored account, such as a 401(k), you have the option of working until you die. If you continue to work past age 70 ½ and you are still participating in your company’s 401(k) plan, you can defer your RMD until April 1 following the year you retire, providing you are no more than a 5% owner in the company. Theoretically, if you were able to work until the day you die, you could avoid paying any taxes yourself and pass the tax implications along to your beneficiaries. However, your health may not allow you to work as long as you wish. Furthermore, when you do take your RMD, it is calculated based on the account balance as of December 31 of the prior calendar year divided by the IRS’ actuarial estimate of your remaining life span. By continuing to work, you continue to save to the account with salary deferrals and employer matching contributions; therefore, the balance is growing. When you are eventually forced to withdraw, you will be using a smaller divisor because of your age, which will yield a larger withdrawal. Since RMDs are taxed at ordinary tax rates, a substantial withdrawal could easily push you into a higher income tax bracket. This exception does not apply to 401(k) plans with former employers.
For those investors who have a traditional IRA and want to avoid the withdrawal solely because of taxes, Congress made qualified charitable distributions a permanent tax break. This allows you to direct some or all of your required minimum distribution from your IRA to a qualified charity. You do not get to take a tax deduction for the charitable donation, as you likely received a deduction for the IRA contribution; however, the distribution to the charity is not included in your income, so no taxes will be due. Of course, this works best when you do not need your money for living expenses in retirement.
As advisers, we see tax avoidance as a behavioral issue. So often investors make decisions that simply do not make mathematical sense. You wouldn’t owe the taxes if you never had a gain in your portfolio. You have to take the good with the bad, otherwise, why go through the trouble to save money for retirement if you don’t want to spend it? A trusted financial adviser can help you during your saving years to ensure you have a good mix of tax-deferred and tax-free savings for your retirement, which can help mitigate your disdain for paying taxes. Furthermore, it is the adviser’s job to help you minimize your tax liability by helping you balance other areas in your financial life.
If you have questions regarding how your retirement assets will affect your tax liability, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
Disclosures: This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
