For decades, we investors have been encouraged to defer the taxes we pay: By investment companies, by our employers, by financial advisors, and even by the government that’s supposed to be collecting those taxes.
Every baby boomer has learned that deferring taxes as long as legally possible in 401(k)’s, IRAs, deferred compensation plans and similar investing vehicles—is what smart Americans do. Delaying taxes means more money to invest, more compounding, and ultimately more wealth. So far, so good.
But when it comes to taxes, every rule has exceptions. The higher your age and the greater the assets in your tax-deferred retirement account (or accounts), the greater the risk that your deferral reflex will backfire, leaving you to fight an uphill tax battle in your golden years.
To be very clear, you are technically free to keep all your money in a tax-deferred account such as an IRA–and even keep contributing to the account–until age 70½. Assuming that the markets cooperate, your money will continue to grow, tax-deferred, right up until the minute you start taking it out. It can grow and grow until your IRA is as plump as possible.
But that’s where trouble lurks. At age 70½, you must start taking required minimum distributions from your IRA. If your “defer, defer, defer” strategy has been successful, your account could be huge. But the bigger your account, the more you are required to withdraw each year. And since IRA withdrawals are considered ordinary income, your new flood of income could very well push you into a higher tax bracket than necessary.
One way to avoid this scenario is to begin gradually drawing down your IRA well before age 70½. Of course, when you take these relatively small distributions, you will pay taxes. And that can seem painful at the time. But if you follow a well-planned strategy in sacrificing some of your tax-deferral power, you are likely to come out far ahead in the end.
Let’s take the example of a married couple, John and Jane Doe. They are about to turn 60, and they have a combined total of $1 million in their two IRAs. Although they are eligible to start taking distributions at age 59½, they decline to do so. Let’s assume their IRA assets earn a 9% return each year.
When John and Jane reach age 70½, they have a hefty combined IRA balance of about $2.5 million—which will result in a required minimum distribution in that year of approximately $94,000. Combined with Social Security and other sources of income, this hefty distribution could easily land them in the 28% Federal tax bracket (plus any state income tax if applicable).
Bear in mind that John and Jane’s required minimum distributions will quickly go higher after that first year. Assuming that their rate of return remains at 9% annually, and that they take out only the required minimum each year, by year five John and Jane will have to take a distribution of almost $133,000. In year ten it would be above $200,000, which would almost certainly cement them into the 33% Federal tax bracket.
Now let’s say that John and Jane had taken $60,000 a year from their IRAs each year starting at 59½. Over 11 years, they would have taken out a total of $660,000–using it for vacations, gifts to grandchildren or even just saving it up in a taxable brokerage account. As a result of their voluntary distributions, their required minimum distribution at age 70½ would have been just about $56,000. It’s quite conceivable that, as a result of their planning, this couple would be able to remain in the 15% tax bracket rather than the 25% or 28% bracket.
Our example is fictional, of course. But as more and more Baby Boomers carry large IRA balances into retirement, a troubling trend is unfolding: Too many are wrestling with an unexpectedly large tax burden.
Tax-deferred saving usually serves us well when we’re younger. But as retirement age approaches, the need for more careful tax planning becomes critical. And that can require you to unlearn the deferral reflex. If you’d like to discuss retirement tax planning, please don’t hesitate to contact us.