Successful Retirement or Tax Trap; Will You Be The One Who Pays More In Tax During Retirement?
by: Jeremy Reif, CRPS
If you are/were successful in your career and saved enough to retire, congratulations! The Internal Revenue Service (IRS) would also like to thank you. If you knew the tax trap existed, you might not have known its full extent. This article is focused on the hidden tax trap, which mostly affects the middle class and up. People tend to forget that the government is around indefinitely; we are only here temporarily. How does that old saying go? There are only two things that we can count on: “death and taxes”.
The Trap In Plain Sight
It is human nature to want to pay as little tax as possible every year. Our society judges Certified Public Accountants (CPAs) or tax preparers based on who owes the least amount of tax for the current tax year. Many try to reduce the present amount of taxes on their current income by deferring into a traditional individual retirement account (IRA) or company retirement plan like a 401(k), while on the job and when one is in their peak earning years.
Many have been taught the following advice: Deferring income during your working years and taking distributions during retirement when there is no income coming in. They also hope that during their retirement years, they can take their deferred income out with a lower tax rate than when they were working. What most do not realize is that investing money in a traditional retirement account is a hidden tax trap designed by the government.
Many retirees end up compounding taxes upon taxes and can’t get out of this vicious circle. Otherwise, they believe that they do not have a tax problem, because it has not affected them yet. Taxes and the IRS could be compared to the old question, How do you boil a frog? You can’t throw a live frog into a boiling pot of water, as the frog will jump out. You have to slowly turn up the heat. This is essentially what the IRS does. The IRS requires your distribution percentage to rise the older you get. People realize that when the money is distributed from their retirement accounts, it will be taxed as ordinary income.
Tax Issues
- When should you start Social Security? Is S.S. taxable?
- Do you have a pension, and when should you elect it?
- What account should I take money from first?
A natural thought is to pay as little tax as possible. Most do-it-yourselfers, even less educated financial representatives, and some accountants try to avoid paying unwanted taxes and spend their checking, savings, and brokerage accounts (non-qualified accounts) first. Ultimately, they are deferring taking their distributions from retirement accounts even further into the future. Spending cash first only compounds potential future tax liabilities. Most investors don’t leave their money in cash; they are invested in something that keeps pace with or exceeds inflation. More growth equals more future taxes.
Current Tax Environment
Personal tax rates are at historic lows from the “Bush tax cuts” and Trump’s “Tax Cut and Jobs Act,” which expire at the end of 2025. In the past, we have seen federal tax rates as high as 94% in 1944.
Medicare and Social Security are grossly underfunded and on the brink of bankruptcy. The reality is a program that is funded by taxpayer dollars can’t realistically go bankrupt. The only way it can be bankrupt is if the US monetary system collapses and goes bankrupt because of the national debt. Another problem is that there has not been anyone in office since President Clinton, who has been able to provide the U.S. with a balanced budget.
The second latest addition is “Obama Care.”. It has not exactly worked the way it was originally intended to. Meaning, it has not standardized or commoditized the costs in the medical field. As an example, a knee replacement can cost $50,000 in one medical facility, and if you pay cash, it can be as low as $19,000. Affordable Care Act, and the insurance was supposed to help standardize costs, but it didn’t. Now the government has to help subsidize these insurance plans as well. The hope was to get more people to pay for insurance by getting more people who were not filing a tax return to file one, but this has not happened either.
The last government subsidy stemmed from the shutdown and stimulation of COVID-19. Spending more than $5 trillion and adding this to our nation’s debt. American citizens are responsible for paying back the interest on the debt of our nation. Before COVID-19, the tax revenue was not enough to balance the budget. Adding $5 trillion and the ensuing interest owed on the additional amount means this will be an even bigger struggle. This problem will be exponential, especially after interest rates rose from approximately zero to around five percent.
The Fix
The consensus is that the government will need to increase future taxes or find a way to change our current tax system as a whole. The easiest fix is to raise taxes, and we are already seeing this happen. Social Security, in late 2015, closed one of their loopholes around the ability to file and suspend. Medicare premiums have gone up.
The Trap
Getting back to what all of this means about your retirement and the taxes you will pay. For those who defer large amounts of money into retirement accounts and don’t plan on touching them, your family will likely pay higher taxes than necessary. Primary beneficiaries on retirement accounts are typically spouses. This only makes sense, as it is the only person who can inherit the traditional retirement account without having to pay current income tax on the transition from one spouse to the other. To be clear, this is the tax trap and what the IRS is hoping you will do.
After the first spouse passes, the money is transferred into the widow’s name. The widow will now file taxes as an individual (assuming the widow does not remarry). Now that all the money has been transferred to the widow; the widow (assuming they are 73 or older) is still required to take the RMD, but has a smaller tax bracket to shelter the taxes paid. The result is that the widow is now in a higher tax bracket than when married and filing jointly.
Many wealthy people could find themselves in a higher tax bracket after the first spouse passes than while they are in the peak earning years of their lives. This situation will only get worse if tax rates go up in the future. To make matters worse, if the spouse does not take all of the money out of their retirement accounts and passes away, their beneficiaries (typically their children) will pay an inheritance tax called income in respect of the decedent (IRD).
An Idea
There are many ways to reduce the taxes you will pay over your lifetime. One in particular is worth mentioning. The government has allowed people to have contributory Roth IRAs and allowed conversion to Roth IRAs. However, most people do not understand if they should or should not utilize Roth retirement accounts.
When the Roth first came out in 1997, most were advised that it was typically for younger people. The new way of thinking is that Roth’s should be strategically used for almost everyone. The advice as to when and how is very specific, especially for those who have the potential to be in higher tax brackets later in life based on their given financial situation. Many other tax-friendly strategies should be deployed going forward. Attorneys and politicians typically come up with new tax codes; which means they know how to use older tax codes or loopholes to reduce their tax liability. It is up to you to figure out these tax code opportunities or to hire a financial planning professional who can help you navigate a lower tax for your future.
Sources:
Historical Highest Tax Rates – https://www.taxpolicycenter.org/statistics/historical-highest-marginal-income-tax-rates
Required Minimum Distribution Table – https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmds
Nations Debt Clock – https://www.usdebtclock.org/