Are you creating a tax burden for yourself in retirement or for your kids after you’re gone? Responsible savers
who carry little or no debt and are otherwise financially responsible often end up creating a future tax burden
for themselves and their heirs without realizing it.
Start with Retirement Savings 101: Your 401k account. Traditional 401k contributions consist of pre-tax
dollars, which are dollars from your earnings deposited into your 401k, and the taxes are deferred into the
future, i.e., retirement. The key word here is deferred.
Any good accountant will recommend making traditional 401k contributions because the individual will receive
a tax deduction each year equal to the total contribution. A no-brainer, especially for high-income earners,
right? Not entirely. This is where the financially responsible, good saver learns the difficult truth deep into
retirement and wishes they had done things differently.
The tax burden is typically created by Required Minimum Distributions (RMDs). At a time in your life
determined by the government (currently age 73), you are required to begin taking annual minimum
withdrawals (RMDs) from your retirement accounts, which in most cases are fully taxable. Most people don’t
realize this amount is a direct function of your pre-tax retirement account balance at the end of each year. The
higher the balance, the higher the annual amount, thus the higher the tax. In addition, every year you age, the
more you must take, even if the account balance stays the same. This is because the calculation uses a life
expectancy factor. The amounts quickly ramp up the closer you get to life expectancy.
Projections are run during the financial planning process to determine your balances by the time you reach
RMD age. This presents a question: Will you need this much annual income at the RMD age? If you were
financially responsible throughout your lifetime, this annual amount could be much more than you need,
triggering a large amount of unnecessary tax.
The next projection is life expectancy, or when the last of you and your spouse are expected to die. This is
when the next tax burden is triggered. In a common household, upon death, assets shift from one married
spouse to the other without issue. But this tax burden is triggered when the second spouse dies, when kids or
other non-spouse beneficiaries inherit those pre-tax retirement accounts. These inheritances are now subject
to their own RMD, and the beneficiary must start taking them in the year following death.
Before 2020, when non-spouse beneficiaries — typically kids — inherited traditional retirement accounts, they
could spread the tax over their lifetime; now it’s only over 10 years. Because the distributions are escalated, so
is the tax. Our government is sneaky. In a real-life scenario, when the second married parent passes, their kids
are probably in or approaching their highest earnings years. Keeping this in mind, when they are forced to take
a much higher distribution from their inheritance, they will likely be pushed into an even higher tax bracket,
triggering the tax burden. Under old rules (pre-2020), the annual required amounts were much less. Thankfully,
those beneficiaries are grandfathered into the old rules.
The government has increased the RMD age over the past few years from 70.5 to 72. Now it’s 73, and by 2033,
it will be age 75. They make you feel like they’re doing you a favor, but they plan to collect more taxes when
your kids inherit these accounts by escalating the inheritance distribution over 10 years.
To add fuel to the fire, one can also assume our tax rates will be less favorable in the future, so the actual tax is
likely to be higher than projected. Unfortunately, this variable cannot be projected accurately because it’s
based on government policy and will change from one administration to the next. This poses a new question:
If you can avoid higher taxes in the future, wouldn’t you do so?
To reduce or prevent these future tax burdens, proper planning and execution are essential. The Qrst
consideration is to stop making pre-tax contributions to your 401k and switch them to Roth. The main
difference is you pay tax on those earnings when the money goes into the Roth and are exempt from tax when
you take distributions in retirement (after 59.5 years old); very powerful. Most 401ks have this Roth option
available, and you can contribute to them regardless of how much money you make (Roth IRAs have income
limits). Before doing this, you need to consider the consequences of paying higher taxes now versus in the
future.
Another option is to do Roth conversions, which must be done carefully and typically work best if spread out
over many years. Tax planning with experts before the conversion is highly recommended.
In addition to Roth, saving into taxable investments is another great option. These accounts are much more
hexible, meaning they can be used for anything, not just retirement. The main differences are that no income
or contribution limits exist, no penalties for early withdrawal and how taxes are triggered and calculated.
Within these accounts, taxes are not triggered when money is taken out of the account but rather when
investments are sold each year. This is a capital gains tax, which, as of now, is a lower rate than ordinary
income tax. These taxes can even be somewhat controlled from one year to the next within the right
investment strategy through tax harvesting.
An effectively executed tax strategy begins with a detailed plan and must be implemented over many years to
be successful. Engaging with an expert in Qnancial planning to develop a detailed tax plan is the Qrst step to
preventing or reducing these future tax burdens.
Andy Roberts is a private wealth advisor at Employee Retention Solutions, an RDG+Partners company, which
provides businesses across Upstate New York with a holistic solution for payroll, employee beneCts, and
retirement services enhanced by proven technology and boutique-level service for streamlined processes. For
more information, visit www.rdg-ers.com.
Securities offered through Cambridge Investment Research, Inc., a broker-dealer, member FINRA/SIPC. Advisory
services offered through Cambridge Investments Research Advisors, a Registered Investment Adviser. RDG
Wealth Management, LLC and Cambridge are separate entities, independently owned and operated.
These are the opinions of RDG Wealth Management and not necessarily those of Cambridge Investment
Research, are for informational purposes only, and should not be construed or acted upon as individualized
investment advice. Cambridge does not offer tax advice.
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