retirement

Should You Defer Your Taxes Until Retirement?

When it comes to taxes, there's an expensive difference between smart planning and just plain procrastination.

Tax deferral can be a powerful incentive for funding a retirement account.

It is difficult to ignore the allure of a plan that allows you to save on taxes now as you save money for retirement. This helps explain why Americans have more than $5.8 trillion invested in employer-sponsored 401(k) plans. According to a recent Harris Poll (commissioned by TD Ameritrade), Americans consider not investing in a 401(k) the biggest financial mistake one can make.

Inevitably, most folks need some motivation to save for retirement. They certainly did back in the mid-’70s and early ’80s when IRAs and 401(k)s first became available, and they still do today. It is also clear now — after decades of watching savers deal with these plans — that tax deferral can be a trap, especially for high-net-worth retirees.

A Tax Trap for the Wealthy

How can this be? We’ve been told for as long as IRAs and 401(k)s have existed that it’s smart to put as much money as possible into these tax-deferred vehicles, because most workers may be in a lower tax bracket during retirement. However, we’ve found that the higher one’s net worth is, the less likely this is to be true. People grow accustomed to a certain standard of living and want their retirement to be just as comfortable as their working years — if not more so. That requires income.

What many retirees may not realize is that even if their income requirements are the same or lower than when they were younger and working, some important tax deductions may go away as they age. Their mortgage might be paid off. Their children likely are grown and out of the house. Some retirees may be unprepared for the single-filer tax rate they must use upon the death of a spouse.

On top of that, what if tax rates go up? Our country’s record-breaking deficit spending can’t go on forever. Government spending must be cut or tax revenue increased, regardless of any “Medicare for All” or “Green New Deal” policy implementations.

What Will Your Tax Bracket Be in Retirement?

Withdrawals from tax-deferred accounts are taxed as ordinary income. Yet, we see people with a staggering percentage of their net worth in these accounts. Numerous pre-retirees and retirees come to our office and enthusiastically describe their strategy to put off taking retirement account withdrawals for as long as possible. Many plan to wait until they have to take required minimum distributions (RMDs) at age 70½. Some are excited that the proposed SECURE Act could delay RMDs to age 72.

While this strategy may seem appealing now, it may be a bad long-term decision. RMDs alone could drive some of these retirees into higher tax brackets than they were in during their working years. For some, deferring taxes is nothing more than procrastination.

It turns out that taxes are the single biggest expense for many retirees. We find they often just accept it, year after year, thinking there is nothing they can do.

Of course, that isn’t so.

Time to Get Proactive about Taxes

Investors today are trained to manage investment costs, to prepare for inflation, to think about health care and long-term care costs, but most do not know how to plan for taxes.

We recommend taking a proactive approach to taxes by obtaining a comprehensive retirement income analysis well before retirement. Using computer software, financial professionals can conduct detailed assessments of individuals’ or couples’ investments and other assets, spending needs and wants, Social Security claiming options, and other sources of income. The software then calculates the most, tax-efficient strategies to help maximize income for life and, if desired, provide a legacy for loved ones.

It is also important to become informed about tax diversification, which means putting retirement savings into three buckets: a pre-tax bucket, an after-tax bucket and a tax-free bucket.

  • The pre-tax bucket includes the accounts discussed above: IRAs, 401(k)s, 403(b)s, etc., which are not taxed until you withdraw funds (and generate 1099s later).
  • The after-tax bucket includes checking accounts, savings accounts, brokerage accounts and other accounts that are taxed currently and generate 1099s.
  • The tax-free bucket includes Roth IRAs, Roth 401(k)s and properly structured cash value life insurance policies.

With some savings in each of these buckets, you can more easily manage your withdrawals to stay within a targeted tax bracket.

For younger workers saving for retirement, it may make sense to work with an adviser who understands and embraces the concept of tax diversification. In my opinion, it’s best to start balancing the money in those buckets sooner rather than later. The cost of tax diversification can be high if you wait until retirement to get started.

The Bottom Line

Tax-deferred accounts have a valuable role in a retirement savings plan. Every employee should take maximum advantage of employer contributions offered in a workplace plan, for example. This is free money.

Beyond that, it’s a mistake to assume it’s always best to defer your taxes until retirement. Work with a qualified professional as well as your tax adviser to carefully assess your individual situation.

Securities and advisory services offered through Sunbelt Securities, Inc. Member FINRA/SIPC. Fixed life insurance and annuities offered through Charles W. Rawl & Associates, LLC. Charles W. Rawl & Associates, LLC and Sunbelt Securities, Inc. are unaffiliated companies and neither provides tax or legal advice.

Kim Franke-Folstad contributed to this article.

About the Author

Charles Rawl, CFP®, RICP®

President, Charles W. Rawl and Associates

As president of Charles W. Rawl & Associates, LLC (www.cwrawl.com), Charlie Rawl has distinguished himself as a troubleshooter by implementing creative solutions to complex financial problems. He has passed the Series 6, 7, 31, 63 and 65 securities exams and holds life insurance licenses in more than a dozen states.

Most Popular

Don’t Be Tricked Into Voluntarily Paying Higher Taxes on Your IRA
IRAs

Don’t Be Tricked Into Voluntarily Paying Higher Taxes on Your IRA

Traditional IRAs are set up in a way that basically incentivizes you (and your heirs) into paying the highest tax bill possible. Don’t fall for it. Co…
July 4, 2022
Your Guide to Roth Conversions
Special Report
Tax Breaks

Your Guide to Roth Conversions

A Kiplinger Special Report
February 25, 2021
The 15 Best Stocks for the Rest of 2022
stocks to buy

The 15 Best Stocks for the Rest of 2022

The lesson of the past two years: Be ready for anything. Our 15 best stocks to buy for the rest of 2022 reflect several possible outcomes for the seco…
June 21, 2022

Recommended

Has Bad Economic News in 2022 Hurt Your Retirement Plans?
retirement

Has Bad Economic News in 2022 Hurt Your Retirement Plans?

How the right plan now can get you back on track and reduce the risk going forward.
July 6, 2022
With High Inflation and an Uncertain Stock Market, Do I Have Enough to Retire?
retirement

With High Inflation and an Uncertain Stock Market, Do I Have Enough to Retire?

If you’re at all concerned then it’s time to do some analysis, either with a financial professional or even just on your own. Answering a few question…
July 6, 2022
Age Magnificently with the Help of a Geriatric Care Manager
retirement

Age Magnificently with the Help of a Geriatric Care Manager

Geriatric care managers help families map the coming changes and explore the options before they are even needed.
July 5, 2022
Don’t Be Tricked Into Voluntarily Paying Higher Taxes on Your IRA
IRAs

Don’t Be Tricked Into Voluntarily Paying Higher Taxes on Your IRA

Traditional IRAs are set up in a way that basically incentivizes you (and your heirs) into paying the highest tax bill possible. Don’t fall for it. Co…
July 4, 2022