“The best way to teach your kids about taxes is by eating 30% of their ice cream.”
–Bill Murray
“Retirement is not the end of the road. It is the beginning of the open highway.”
–Unknown
Hello everyone.
There are a lot of opinions about retirement and taxation.
Retirement can be an incredible blessing. I retired at 50, have traveled to over 50 countries, built a small fortune, and did what I wanted to do—including helping others through a small nonprofit I currently manage.
However, it does not happen by accident. To get a good retirement, one pundit opined that you put 15% per year into a retirement fund and treat it as an ongoing expense.
That is good advice. It is just incomplete and does not consider the kinds of taxes you pay and their timing. After all, it does not answer what accounts, or a combination of accounts, work best or protect you when you retire. It does not talk about taxes or tax savings either. And it does not evaluate common risks in retirement.
It turns out that the government gives you two main types of tax breaks when you save for retirement in traditional and Roth accounts. You need to choose one or a combination of both and decide what is best for you.
That is why I wanted to discuss the subject more fully. I also want to highlight a few hidden risks related to the types of accounts you can open.
TRADITIONAL IRA (INDIVIDUAL RETIREMENT ACCOUNT)/WORK ENROLLED PLAN, 401k etc.
First, let’s discuss the basics of traditional retirement accounts. Here are the main points you need to know:
- Contributions are usually tax-deductible (but check with your fiduciary advisor to see for sure)
- Earnings grow tax-deferred.
- Withdrawals in retirement are taxed as ordinary income. Income and are subject to the taxation rate of whatever bracket you are in at the point of withdrawal.
The last point is critical. Once retired, the taxman gets a cut every time you withdraw from this type of account.
So, why are IRA plans so popular? Besides tax-deferred growth, there are some striking advantages to saving for retirement this way that include:
- Tax Deductibility—Contributions may reduce your taxable income in the year they are made. This can provide a tax benefit and is one of the few ways to shelter income.
- No Income Limits for Contributions–Anyone with earned income (from a job) can contribute. However, the deductibility of contributions may be limited based on income and retirement plan participation.
- Compounding—over time, the benefits and growth of money can be extraordinary. See here.
Of course, nothing is free or perfect. This sort of plan does include early withdrawal penalties. Withdrawals before age 59½ typically incur a 10% penalty plus income taxes, though exceptions exist.
Required Minimum Distributions (RMDs) for most people must begin at age 72 or 73. You must start those distributions, whether you need the money or not, forcing you to withdraw and pay income taxes on the funds. Check with your advisor about the start date, as they vary depending on your situation and the kind of tax-deferred plan you enroll in.
A SURPRISE BENEFIT FROM A TRADITIONAL ACCOUNT THAT MANY PEOPLE DO NOT TAKE ADVANTAGE OF
If you are using a traditional IRA or employer-enrolled plan, you are reducing your tax liability.
However, most people should take advantage of the monetized tax savings and consider what to do with them. Most don’t.
Let me give an example of what monetizing tax savings means. Let’s suppose that you put $10,000 into a traditional retirement account. If you have an above-average income, you may save 30% of your State or Federal taxes on that $10,000 contribution. That means you save $3,000 in tax.
So, why not take those tax savings of $3,000 and invest them if you can do so?
I believe retirement is a mandatory expense while working, such as buying food and paying the rent. So, it is best to treat it like an expense, complete with tax consequences. If you can afford to reinvest the tax savings, do it.
ROTH IRA’S
If readers are not already doing so, they should consider investing in a Roth IRA. It would be an excellent use of monetized tax savings.
Lately, there has been a lot of talk about investing and converting traditional accounts into Roths. See here.
No matter which political party takes office, the Nation has bills to pay, and taxes are likely to rise. If that happens, the lack of taxation on Roth accounts will make them particularly valuable. However, avoiding future taxes is only one of the reasons you should consider a Roth.
Here are some of the characteristics of this kind of investment account:
- Contributions are made with after-tax dollars, so individuals don’t get tax deductions.
- Earnings grow tax-free.
To sum it up, here are why many people invest in Roth IRAs:
- Withdrawals in retirement are tax-free, provided you meet the requirements. Usually, the account must be at least five years old, and you must be 59½ or older.
- There are no Required Minimum Distributions (RMDs).
That allows your money to grow tax-free for as long as you want or can, and you control the timing of withdrawals.
- Contributions (but not earnings) can be withdrawn without penalties or taxes, making Roth IRAs somewhat flexible for emergencies.
- Roth’s gives you the maximum flexibility on taxation and timing. Traditional accounts have more “strings” in their use, which can limit them.
COMMON RETIREMENT RISKS AND YOUR RETIREMENT FUNDS
Our ratio of Traditional to Roth is about two-thirds to one-third. We also have real estate and other investments, including cash, to help during retirement.
We have arranged our retirement accounts to deal with particular kinds of risks and expenses.
What follows are four risks you can deal with but not completely control. You can read about some others here, but they are not related to the structure of the account itself. The impact depends on what kind of accounts you have.
- A significant unexpected expense. In retirement, the most likely suspect is medical costs. You may have to withdraw much of the cost from retirement accounts to fund them.
When that happens, your retirement funds may take a hit.
WINNER: Probably the Traditional IRA if the expense is medical. Much of the cost might be deductible, not impacting your tax. As an aside, people who wish to continue making charitable contributions in retirement also gain by taking qualified charitable distributions (QCDs) without paying taxes.
- A poor economy that causes a large RMD.
RMDs are calculated based on your remaining life span. For instance, if you are 73, divide your IRA balance on December 31st by 26.5. That amount is your RMD for the year.
The older you get, the higher the withdrawal percentage. For some seniors, it might easily be 5-10% of the previous year’s account balance on December 31st.
However, the situation can be much worse with a sharp economic contraction. For instance, in 2007, the S&P 500 Stock market index rose 5.49%. The RMD for 2008 was based on the January 31st value of your holdings. However, in 2008, the S&P 500 index declined 37%. So, when you take your yearly RMD from a traditional IRA account that has dropped by almost 40%, you have a significantly reduced amount left in your IRA. You get hit by the loss of value and still have to withdraw from the reduced account balance. That is what happened to some retirees in 2008.
WINNER: Nobody. A cost is a cost. But in some circumstances, a forced withdrawal can be avoided in a Roth if there are other resources you can use instead to pay medical bills. Liquating retirement funds at the bottom of the market can worsen your finances.
- A combination of the first two. Ugh. This happened to some in 2008 and probably again in 2022.
WINNER: in some circumstances, a forced withdrawal can be avoided in a Roth if there are other resources you can use to pay bills instead. That leaves funds in the Roth that can generate tax-free money for future expenditures.
- Tax risk from future tax rate increases.
Future tax increases will probably not affect the tax-exempt status of current Roth accounts. You never know with Congress, but retroactive tax increases are unlikely and not the norm.
WINNER: the Roth account.
SUMMARY/DISCLAIMER:
To understand the nuances of each type of retirement account, you need to consult with a financial fiduciary. I have simplified this subject so that the basic concepts are clear. That does not substitute for doing homework if you are considering opening a retirement account.
For instance, traditional retirement accounts vary depending on whether you enroll through your employer or establish your own account.
This post gave the basics in the first part to set the stage for the last section and the real point of this post: retirement risks related to account type. No one advised me about the endgame consequences of my decisions. And 40 years ago, I would not paid any attention. However, opening or converting to a Roth is worth considering for many people as they approach their retirement date.
Disclaimer: consult with a financial fiduciary before taking any steps outlined here. Not all advice may be suitable for your circumstances or investment style.
Photo: Caleb Jones
License: Unsplash
Thanks Highwayman! As always great stuff!!
I wish someone had told me this 30 years ago.