Your 401(k)s and IRAs Have a Dark Side

Two people can look at a Rorschach ink blot and one will see a refined, beautiful woman and another will see an old spinster.

The same can be said of your retirement savings. You can also look at a retirement account and see all the good points or look at it from a different perspective and see all the shortcomings.

It's easy to find information on the advantages of a pretax retirement account, like a traditional IRA or a 401(k), including the tax savings, the tax-deferred growth, and providing a source of retirement income.

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What you don't hear about as often are the disadvantages of such accounts. Knowing what those are may help you strike a more sensible balance in how you save money.

Problems with Your Estate Plans Can Crop Up

For starters, one downfall of pretax retirement plans is that it can be easy to make a mistake when planning for how your heirs will inherit them. People often mistakenly believe that because they have a will or a trust, their bases are covered, but pretax retirement plans are not directly regulated by an estate plan.

Instead, your “beneficiary election form” determines what happens to your retirement account after you die. In most cases, the attorney who is drafting a will or a trust doesn't get involved in properly titling names on this beneficiary form.

Because of this, often the heirs named on a beneficiary form are not titled the same as they are in your estate plan, which can cause problems.

For example, when an attorney drafts a trust, they will often use “per stirpes” language, which keeps each heir’s share of an inheritance in their bloodline, if they pass prematurely.

Because the typical retirement plan owner titles their own beneficiary form without the help of an attorney, very rarely are they aware of such language.

For instance, say a man owns a retirement account and plans that his three sons (and their children) will inherit it equally. If the man and one of his sons were both killed in a car wreck, without per stripes language, the deceased son’s share of the retirement account would go to the surviving co-beneficiaries, and his children would get nothing.

Also, keep in mind that if you update your heirs in your estate plan due to divorce, birth, death or something else, it does not automatically update your beneficiaries on your retirement account. This could result in the wrong person or persons getting your retirement assets at your death, like an ex-spouse, if you forget to update your beneficiary form.

Tax Bombs Hide in Pretax Retirement Accounts

Pretax retirement plans, such as traditional IRAs and 401(k)s, never receive the more favorable long-term capital gains tax treatment that taxable brokerage accounts enjoy. To illustrate, compare the tax treatment of gains in a taxable account against those of a pretax retirement account:

Example 1: You owe $13,500 in taxes on a taxable investment. Say a stock purchased for $10,000 in a taxable account grows to $100,000 over the next 20 years and is then sold. This will trigger a $90,000 long term capital gain. If you were in a 24% tax bracket, instead of paying 24% of the $90,000 in taxes (a tax bill of $21,600), the gain would be taxed at a 15% long-term capital gain tax rate, resulting in a reduced tax of $13,500.

Example 2. You owe $24,000 in taxes on a similar pretax investment. However, if the same thing was done inside a pretax retirement account, you would not receive the more favorable long-term capital gain tax treatment if you took the sales proceeds out of the account. In this case, the full $100,000 would be taxed in your 24% tax bracket, resulting in a tax hit of $24,000 — or $10,500 more.

As for inheriting stock, the same principles hold true: Pretax retirement accounts are at a disadvantage when compared to taxable accounts. Let’s look at a similar scenario where a man purchased stock for $10,000 in a taxable account and it appreciates to $100,000. Say the man dies, leaving the shares to his son. In this case, all taxable appreciation up to the day he died is forgiven when the son sells, i.e., the cost basis of the shares is “stepped up” to the value on the date of the man’s death. So, in this case the son would inherit $100,000 tax free. He would only owe taxes on any gains above that $100,000 that occurred between his father’s death and when he actually sold the shares.

This can result in huge tax savings where a lot of highly appreciated investment securities are involved.

This would not be the case if the same stock was owned inside a pretax retirement plan. When the son sold his stock after his father’s death, and withdrew the proceeds, the entire $100,000 would be fully taxable as ordinary income. If he was in the 32% tax bracket, he would pay $32,000 in taxes.

Pretax Retirement Accounts Fall Short as a Gift Vehicle

Money in a traditional IRA or a 401(k) or other pretax company retirement plan cannot be gifted directly, as would be the case in a taxable non-retirement account.

In 2020, the annual gift tax exclusion is $15,000. This means if you have money in a taxable brokerage account, you can make a gift of up to $15,000 to as many people as you like without having to deal with gift tax consequences. The gift is not taxable to the donor when made, nor is it considered taxable income to the recipient.

On the other hand, money taken out of a pretax retirement account to make such a gift would trigger ordinary income tax upon withdrawal. In a 22% tax bracket, $3,300 in taxes would have to be paid upon withdrawal of the $15,000 before the gift could be made to recipients, such as your children.

Don’t Forget about RMDs

Pretax retirement accounts also have taxable required minimum distributions that you must start taking in the year you turn age 72, and even sooner in the case of a pretax inherited IRA. These distributions drive up your income, boosting your tax bill, and they are mandatory, whether you like it or not.

There are no such forced distributions that trigger tax on other assets.

Striking Balance

While the disadvantages of 401(k)s, traditional IRAs and other pretax retirement accounts don't invalidate the wisdom of putting money in them, they do suggest that there might be a need to strike a better balance between funding a retirement account and a taxable account to diversify your tax strategies.