Remember when you first started earning a decent salary, and it seemed as if everybody — your parents, your boss, the nice lady in HR and, of course, your tax preparer — all told you to put as much money as you could into your employer’s 401(k) plan?
Grab the employer match, they said. Get the growth that the market has to offer. And take advantage of the tax break, for crying out loud. Why not avoid paying taxes on that money now, while you’re in a higher tax bracket, and worry about it later, when you’re in retirement?
But what they didn’t tell you then (because they probably didn’t know) is that as you kept stuffing money into that tax-deferred account, you were chaining yourself to a ticking tax time bomb.
From just $107.88 $24.99 for Kiplinger Personal Finance
Be a smarter, better informed investor.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Because there’s a good chance your tax rate won’t be lower when you retire. And if you don’t do something to help defuse the situation before you start withdrawing money from that 401(k) (or SEP IRA or 403(b)) for retirement income, you could be sending a sizable chunk of your nest egg to the IRS every year.
Why Tax Rates May Go Up in the Future
Don’t think so? Here are just a few points to consider:
- Most people think taxes are too high now, but they could be much worse. They certainly have been in the past. In 2019, the top rate is 37% for individuals whose taxable income is over $510,300 ($612,350 for married couples filing jointly). In 1944, the highest rate — for anyone who made over $200,000 — was 94%. And the top rate stayed high for decades. It wasn’t until 1987 that it dropped below 40%. The current rates, dictated by the Tax Cuts and Jobs Act of 2017, will end on Dec. 31, 2025, and no one knows where they’ll go from there.
- The national debt is sitting at more than $22 trillion, and it’s growing by the second. Most experts agree the only clear way to help reduce the country’s deficit and pay down that debt is for the government to collect more money. (FYI: That usually means taxes.)
- A large percentage of the federal budget goes toward various kinds of social insurance, including Social Security, Medicaid and Medicare. Those programs are funded by dedicated taxes that no longer generate enough revenue to cover their costs. Our leaders can either cut those programs or raise taxes to pay for them.
- Two words: baby boomers. By 2030, when all members of the baby boom generation have reached age 65, the Pew Research Center projects that 18% of the nation will be at least that old. As the aging population continues to tap into Social Security, Medicare and other benefits, it can only further drain the system.
Tax-Cutting Strategies: How to Prepare Yourself
So, you basically have two choices. You can ignore the data, the trends and the experts, and see what happens. Or you can incorporate some tax strategies into your retirement plan now, bring some balance to your portfolio and maybe even get yourself to a tax rate of 0% with these steps:
- Make a list of all your investments.
- Recognize that your investments fit into three different tax buckets: tax always (brokerage accounts, CDs, etc.); tax later (401(k)s, 403(b)s, traditional IRAs); and tax never (Roth IRAs, cash value life insurance, municipal bonds).
- We believe it makes sense for many people to work on a strategy to move money from the tax-always and tax-later buckets into the tax-never bucket. And if possible, do it in the next five years, before the current tax reforms sunset.
As with most investment decisions, the right strategy for you will be based on your personal situation.
One option is to do a Roth IRA conversion — moving money from a traditional IRA or 401(k), paying taxes on it at today’s rates, then letting the funds grow inside the Roth knowing the principal and earnings will never be taxed again. You can do this all at once or, to keep the tax bite lower as you go, convert the funds over a period of years.
Another option is to take the money out of your tax-deferred account and put it into a cash value life insurance policy from which you can take policy loans tax-free. (This is a more complex strategy, however, with some risks, so it’s best done with the help of an experienced financial professional.)
No matter which strategy you choose, if you’re concerned about the money that’s piling up in your tax-deferred accounts, don’t delay. Help defuse the ticking tax bomb before it can blow up your retirement plan.
Investing involves risk, including the potential loss of principal. Insurance and annuity product guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company. Policy loans and withdrawals will reduce available cash values and death benefits and may cause the policy to lapse or affect guarantees against lapse. In the event of a lapse, outstanding policy loans in excess of unrecovered cost basis will be subject to ordinary income tax. Tax laws are subject to change and you should consult a tax professional. All withdrawals from qualified accounts are subject to ordinary income tax and, if taken prior to age 59½, may be subject to a 10% federal additional tax.
Kim Franke-Folstad contributed to this article.
-
Stocks Hit Fresh Highs Ahead of the Fed As Earnings Pump Optimism: Stock Market TodaySHW and UNH were two of the best Dow Jones stocks Tuesday, thanks to solid earnings reports, and MSFT closed with a $4 trillion market cap.
-
Selling Your Haunted House? What You Have to Tell Buyers (and What You Don’t)You don’t need ghosts to spook buyers, sometimes a home’s past is enough. Here’s what sellers should know about disclosure laws, pricing and perception when a property has a haunted history.
-
I'm a Financial Pro: This Is How You Can Guide Your Heirs Through the Great Wealth TransferFocus on creating a clear estate plan, communicating your wishes early to avoid family conflict, leaving an ethical will with your values and wisdom and preparing them practically and emotionally.
-
To Reap the Full Benefits of Tax-Loss Harvesting, Consider This Investment Strategist's StepsTax-loss harvesting can offer more advantages for investors than tax relief. Over the long term, it can potentially help you maintain a robust portfolio and build wealth.
-
Social Security Wisdom From a Financial Adviser Receiving Benefits HimselfYou don't know what you don't know, and with Social Security, that can be a costly problem for retirees — one that can last a lifetime.
-
Take It From a Tax Expert: The True Measure of Your Retirement Readiness Isn't the Size of Your Nest EggA sizable nest egg is a good start, but your plan should include two to five years of basic expenses in conservative, liquid accounts as a buffer against market volatility, inflation and taxes.
-
New Opportunity Zone Rules Triple Tax Benefits for Rural Investments: Here's Your 2027 StrategyNew IRS guidance just reshaped the opportunity zone landscape for 2027. Here's what high-net-worth investors need to know about the enhanced rural benefits.
-
The OBBB Ushers in a New Era of Energy Investing: What You Need to Know About Tax Breaks and MoreThe new tax law has changed the energy investing landscape with expanded incentives and permanent tax benefits for oil and gas production.
-
Ten Ways Family Offices Can Build Resilience in a Volatile WorldFamily offices are shifting their global investment priorities and goals in the face of uncertainty, volatile markets and the influence of younger generations.
-
I'm a Wealth Adviser: These Are the Pros and Cons of Alternative Investments in Workplace Retirement AccountsWhile alternatives offer diversification and higher potential returns, including them in your workplace retirement plan would require careful consideration.
