Qualified retirement accounts like IRA’s, 401k’s, and 403b’s have been gaining in popularity over the last 30 years. They have almost entirely replaced corporate pension and defined benefit plans, with the few exceptions being government employers and union workers. While all of the plans are technically different, they do have several major similarities.
First, qualified retirement accounts allow an investor to contribute money on a tax-deferred basis. Second, they allow the investor to earn interest or gains tax-deferred. And finally, they require minimum distributions of the accumulated funds starting at age 70 ½. So let’s address these items in order.
Tax-deferred contributions
The fact that an “employee” can contribute to their own retirement savings on a tax-deferred basis is a great advantage over many other similar investments. This tax deferral provides two distinct advantages over other investments. First, it effectively reduces the tax bracket of the employee which allows them to save money on current taxes. This is an important planning tool if used correctly; unfortunately it is often over-looked or misunderstood. To provide an example of how it does this, consider the following:
- An employee earns $3,000 per month and is in a 15% income tax bracket. Normally the employee would pay $450 per month in income tax. However, if the employee were to put 10% of their monthly income into a qualified plan, their “effective” tax bracket would only be 13.5%. This is determined be first reducing the monthly income by the amount of the 10% contribution to the qualified plan – $300 in our example. This reduces the taxable income to just $2,700 which is then taxed at the original 15% – $405 in our example. That means that the employee was able to put $300 into their retirement account, but it only cost them $265 to do it because of the $45 per month tax savings.
Second, it can be used to reduce the employees overall tax bracket. Basically this works the same way as the above example, but it would be looked at from a total income perspective. As an example:
- An employee earns $37,000 per year which puts them into the 25% tax bracket for the 2009 tax year. If the employee were to make a 10% contribution to their qualified plan – $3,700, it would reduce their overall tax bracket to 15%. This is because the 15% tax bracket for 2009 ends at $33,950. This allows the employee to save $3,700 at a reduced or effective cost of only $2,840 because of the difference in the tax brackets – an $860 savings.
With a little understanding and planning the tax-deferred savings to an employee’s income can make a huge difference. These tax savings would be further increased with any type of employer match that your plan may offer.
Tax-deferred gains
Tax-deferred gains are probably the most commonly understood part of a qualified plan. In essence, all interest or gains are earned without any current tax liability – meaning that the employee doesn’t have to pay any taxes until the money is withdrawn. Ideally this is done at retirement or after age 59 ½ to avoid penalties.
Unfortunately, for many, this is where the ticking time-bomb starts. Because the gains are initially tax-deferred they tend to grow over time into large pools of cash reserves. Sounds like a good problem to have, but the reality is that many retirees will never be able to spend down these pools of money. Even worse, it isn’t uncommon to see retirees in a higher tax bracket then they were in during their working careers.
How is that possible? The simplest answer is that most retirees who have accumulated a good retirement nest egg also do well at paying down debt, eliminating mortgages, and saving money in other non-qualified accounts like their ROTH’s, stocks, mutual funds, annuities, cash-value life insurance, and bank CD’s or money markets. This effectively eliminates any major tax deductions while simultaneously increases the retirees income and subsequent tax bracket.
Required Minimum Distributions (RMD’s)
For those with money in a qualified plan, RMD’s can be the biggest problem they will face. Retirees that have done well and saved additional money, are receiving social security, and have other sources of income like rental properties or other business interests, RMD’s are a big problem.
At age 70 ½ the money that has been growing tax-deferred in a qualified plan is required to be withdrawn. All of the money doesn’t have to be withdrawn, but the government mandates that annual minimum amounts be removed from the plan and taxed whether the retiree needs the money or not. If the retiree fails to comply with these rules they will incur large penalties – up to 50% of the accounts value, and be forced to take the RMD’s.
Obviously, the problems associated with RMD’s may not apply to all retirees. Some of these issues can be mitigated by proper planning and a structured spend-down plan for all qualified and non-qualified accounts. A “Financial Professional” can easily help a retiree with a structured spend-down plan, but there is still a ticking time-bomb in all qualified plans.
The ticking time-bomb
So what is the ticking time-bomb that faces all qualified accounts? In one word – Taxes! Not just income tax while you’re alive, but income tax called Income in Respect of a Decedent or IRD for your heirs, and possible estate taxes. Depending on the state you live in and the current estate tax limits, these taxes can combine to provide an effective rate of 60, 70, even 80%. No, that isn’t a misprint – 80%. That means that a $1 million qualified plan would only be worth $200,000 to your heirs if you also exceeded the estate tax limits. Even if you don’t meet the estate tax limits, the tax rate could still reach 50% or more just in income tax to your heirs.
So what should you do? First, don’t panic. You have options and there are multiple solutions that can alleviate, minimize, or completely eliminate these problems. Second, schedule an appointment with a “Financial Professional”. Not sure how to do that – read my earlier post on “How to find a qualified “Financial Professional”. Finally, don’t delay – there is never a reason to wait on making your financial future better.
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Hey, nice post, very well written. You should post more about this.