If you could reduce your tax liability every year, wouldn’t the accumulation of those taxes add up to the smallest amount owed over your lifetime? In the short term, this is accurate, but it is the long-term ramifications that matter most. Wise investors need to examine both the advantages and disadvantages of tax-deferred investments.
Every dollar you put into the tax-deferred retirement account is a dollar that WILL NOT be taxed for that calendar year. It seems like an easy choice to defer the taxation; but not so fast, defer does not mean you will never pay taxes on that money. In fact, you will pay tax on the money you put in, and you will also pay tax on the earnings those contributions create. When you begin to withdraw money from a tax-deferred account, you most likely will discover that your original investment has grown nicely, thanks to market growth and compound interest. While investment growth is a good thing, a resulting downside means the tax amount you deferred in the contribution years will be minimal compared to the taxes you will eventually owe once you begin the withdrawals.
You may be thinking, “I will only get taxed on the money if I take it out of the account, right?” You are correct, but the IRS has accounted for that kind of thinking, and I am going to do my best to summarize three scenarios where having large investments in tax-deferred assets can be detrimental to you and your beneficiaries.
When you turn 72 years old, the IRS will require you to take a Required Minimum Distribution (RMD) from your tax-deferred retirement accounts. The more you have in these accounts, the larger the RMD. Depending on your living expenses, your Social Security benefit amount, and your other income sources, this RMD could force you to be taxed on more dollars than you need to maintain your standard of living.
Taxes may not be a major concern while you and your spouse are still living and filing a joint tax return. The problem we typically see is when you or your spouse passes away and the surviving spouse must report as a single filer, and the marginal tax rates almost double for your highest taxable dollars. For example, $80,000 of taxable income as a joint filer is still in the 12% marginal bracket; $80,000 of taxable income as a single filer is near the top of the 22% marginal tax bracket.)
When you and your spouse pass away, your heirs will now assume the tax burden that remains on those tax-deferred investments. After the SECURE Act was passed at the end of 2019, a new “10-year rule” was created that says your non-spouse beneficiaries must empty inherited tax-deferred accounts within a 10-year period, and each dollar that comes out will be added to their Adjusted Gross Income for that year. Depending on the amount that remains, this could have a significant impact on the taxes your children will owe.
The IRS is counting on you not thinking long term when you make your tax-deferred contributions to your 401(k). In fact, it only benefits the IRS for you to think short-term. The good news is that changes can be made, and strategies can be incorporated to limit the damage. At Financial Enhancement Group, we put an emphasis on tax-planning for the families we take care of. Saving taxes for this year is great, but we want you to pay the least amount of taxes over your entire journey.
The Financial Enhancement Group is an SEC Registered Investment Advisor. Securities offered through World Equity Group, Inc. Member FINRA/SIPC. Advisory services can be provided by Financial Enhancement Group (FEG) or World Equity Group. FEG and World Equity Group are separately owned and operated.
