Why Tax-Deferred Accounts Can Present Problems When Your Retire
Lower your tax bill by creating balance
Socking away all your money into tax-deferred plans like 401(k)s, 403(b)s, 457 plans, and deductible IRAs can be good – to a point. That point ends when you create a situation where all your financial assets are inside tax-deferred accounts. This can cause problems once you’re retired because of the way retirement income is taxed.
Taxes on Withdrawals Matter
When you withdraw money from tax-deferred accounts, it will be taxed as ordinary income in the calendar year in which you take the withdrawal.
If you need extra funds for a vacation, purchasing a new car, or helping a family member, the excess funds withdrawn may bump you into a higher tax bracket. You could find yourself paying 25 cents in taxes or more on each dollar that you withdraw.
Withdrawals Affect Social Security Taxation
In addition to withdrawals from tax-deferred accounts being taxed as ordinary income, they can also affect how much of your Social Security income is taxed. Each withdrawal may make more of your Social Security income subject to taxation.
There is a formula that determines how much of your Social Security is taxed. One of the components of this formula is the amount of “other income” you have. Additional IRA withdrawals increase the amount of other income and may cause more of your Social Security income to be taxed.
A few retirees find they pay over 40 cents in taxes per dollar of IRA withdrawals because their IRA withdrawals cause more of their Social Security to be taxed.
This situation cannot always be avoided but if you plan ahead, you may be able to lower the tax consequence by saving in a tax-smart way.
Building Diverse Tax Buckets Can Lower Your Lifetime Tax Bill
Rather than putting all your money into tax-deferred accounts, build up both after-tax accounts to draw from, as well as tax-deferred accounts. Work with a CPA or retirement income planner to estimate your tax bracket in retirement. If it will be about the same or higher than it is now, consider funding Roth accounts instead of tax-deductible IRAs and making Roth contributions to your 401(k) or 403(b) plan (if the plan allows this).
As you near retirement, it will be important to have a balance of after-tax and pre-tax money. Even if you are foregoing some deductions now, by planning ahead you will be creating financial flexibility that may be useful once you are retired.
Use Asset Location Strategies to Save Even More
As you build up tax-deferred and after-tax accounts (what we refer to as a "non-retirement accounts" which can be a brokerage or mutual fund account that is not designated as an IRA), you can use asset location strategies to make your plan even more tax-friendly!
Asset location is the process of strategically choosing to "locate" high turnover, high income generating assets inside tax-deferred accounts, and placing low turnover investments that generate qualified dividend and long term capital gains in your non-retirement accounts where you get a 1099 each year.
By locating assets thoughtfully, investments like taxable bonds (which generate interest income) and small-cap stock funds (which typically have high turnover and generate more short term gains) can kick off this type of investment income inside of tax-deferred accounts where you pay no tax until you withdraw funds — regardless of the underlying investment income activity.
Tax efficient holdings like tax-managed funds, large-cap stock funds, and dividend income funds can be located in your non-retirement accounts where you can take advantage of the lower tax rate that applies to qualified dividends and long term capital gains.
If these same holdings are owned inside your retirement accounts the qualified dividends and long term gains will end up being taxed at the higher ordinary income tax rate - as all withdrawals from tax-deferred retirement accounts are reported as ordinary taxable income and the withdrawal will not retain the underlying character of the income such as dividend or capital gain.
Taxes matter. By creating a balance of tax-deferred and after-tax investment accounts, and locating investment holdings inside these accounts in a tax efficient way, you can save multiple thousands in taxes over your investing lifetime.