Tax Deferral – Great While You’re Working, It Stinks in Retirement

The following is a guest post. Come back tomorrow for an associated book giveaway.

For years we have been told to defer our income from our working years because we’d be in a lower tax bracket during retirement.  That strategy may have worked for people that retired in the last decade.  However, if you’re going to be retiring in the next decade, you may want to reconsider that strategy.  The national debt is over $13 trillion already with future budget deficits expected to push that number over $20 trillion in just a few short years.  How will this debt be repaid?  Or more importantly, who will be stuck repaying that debt?

The 2009 US Retirement Market Report issued by the Investment Company Institute says there is over $16 trillion of untaxed assets sitting in retirement accounts.  If the IRS could get their hands on just a third of those funds, it would take a huge bite out of the national debt.  Retirees could be facing much higher taxes on retirement plan withdrawals in the future.  Upper income retirees may even see excise taxes on their retirement funds.

It is not my intention to speculate on future tax policy or scare you into pulling your money out of retirement accounts.  My goal is to urge people to take a balanced approach to planning for retirement.  The old adage of “not putting all your eggs into one basket” as a warning to diversify should certainly apply to retirement planning today.  I don’t think you want to end up at the end of your working years with all of your savings held in a 401(k) account.  Every time you try to spend a dollar in retirement it will be subject to tax.  And if you draw too much in any one year your Social Security benefits will become taxable and you’ll start to lose your itemized deductions.  Even Medicare premiums are higher for those with incomes over certain levels.

A more prudent approach would be to diversify your retirement savings into 1) taxable accounts – brokerage accounts, mutual funds, savings that have already been taxed, 2) tax-free accounts – your Roth IRA or Roth 401(k) where the money is saved after-tax and the withdrawals are tax fee, and 3) tax-deferred accounts – 401(k), 457, 403(b), Traditional IRAs.  These accounts still have their place and are useful tools for controlling taxes while working.  You want to have some of your funds held in all three types of accounts.  Think of the three places to save as legs of a stool to balance your retirement.

The person that enters retirement with all three legs in place will be able to determine how much they want to pay in income taxes (if any).  This is achieved by choosing how the funds are withdrawn.  They could pull some money from the 401(k) account but not so much that their Social Security benefits are taxed.  The rest of their income could be taken from the Roth or after-tax accounts.  The amounts withdrawn can be varied each year as their tax situation changes.

Implementing this new way of savings will require a little more effort on your part.  You will need to determine how much should be put into each account based on tax implications.  In 2010, a joint filer enters the 25% tax bracket when taxable income exceeds $68,000.  Personal exemptions are $3,650 each and the standard deduction is $11,400.  This taxpayer should only defer enough income to get their gross taxable income to $87,000.  If they make $100,000 they should defer $13,000 into the 401(k) and put additional savings into a Roth IRA.  This same approach can be used for staying below the Medicare premium increase ($85,000 in 2010) and the levels for losing itemized deductions.

There is no better time to be taking a balanced approach to savings.  The last few months of 2010 may very well be the lowest income tax rates we see for some time, especially for higher income taxpayers.  Act now while tax rates are still low to make sure you have all three legs for your retirement.

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Rick Rodgers, CFP®, is President of Rodgers & Associates in Lancaster, PA and author of “The New Three-Legged Stool™  A Tax Efficient Approach To Retirement”.