Your Favorite Retirement Plan May Be Losing Its Appeal

Understanding finances and learning how to be a savvy saver and investor is not intuitive, it is a skill that is learned. Most people enter the financial arena when they are younger with a basic savings or checking account, often opened by or with the assistance of their parents. Learning to manage your finances starts with baby steps, and these accounts help you learn how to budget and save money. Once that’s in place, the next step in the education process typically involves investing a portion of your income for future growth.

For those in their twenties just beginning their careers, this often means adding money to your employer’s company retirement plan, such as a 401(k) or a 403(b). If you don’t have access to either od these, a common alternative is to open an Individual Retirement Account, or “IRA”. The benefit of both the employer plan and the traditional IRA is the ability to save for retirement on a tax-deferred basis. Your contributions are made pre-tax, and these funds are not included in your taxable income for the year, essentially lowering your tax bill. This allows your money to compound and grow more quickly than it would if you had to pay taxes on the contributions and its growth every year. Instead, you’ll be taxed on the funds once you start taking distributions in retirement, at ordinary income rates.

For decades, we’ve been encouraged to contribute as much as possible to these plans, with the idea being that you will be in a lower tax bracket when you retire – and therefore you’ll pay fewer taxes on these funds than if you’d forgone the tax break upfront. Of course, our economic landscape has changed since the traditional IRA and 401(k) first gained widespread use, with IRA’s first becoming popular in the 1970’s and the 401(k) following in the early 1980’s. The highest tax bracket in the 1970’s was 70% and it dropped to 50% in the early 1980s, so we can see how workers believed they’d pay less once they retired and were taking less income.

With today’s rapidly changing markets, legislative environment, rising inflation and most importantly – the extraordinarily large federal deficit - most financial advisors and industry experts predict higher tax rates in the future. In fact, today we are at historically low interest rates, and with little expectation that Congress will be able to balance the federal budget or sustain programs like Medicare or Social Security without some potentially large tax hikes, we’ll all be best served by anticipating higher taxes in our investment and retirement planning strategies.

Not to pile on more bad news, but there’s more. These retirement funds were long considered a great deal for the beneficiaries of inherited IRAs. They could be passed on to children and grandchildren who could “stretch” the income payments from these accounts over many years, further benefiting from tax deferred growth as well as paying the taxes due incrementally. 

Unfortunately, this is no longer the case. The SECURE Act of 2020 eliminated the stretch IRA concept for most non-spousal beneficiaries and requires that these funds be withdrawn systematically over a ten-year period. Not only do beneficiaries now need to empty the account in a shorter period of time, but they also need to pay taxes on these funds at a time when they are often in their highest earning years, furthering increasing their total tax bill.

Ed Slott, widely regarded IRA expert and author of "The Retirement Savings Time Bomb Ticks Louder", has said that these accounts are now, “probably the worst possible asset to leave to beneficiaries for wealth transfer, estate planning, or even to get your own money out,” he stated.

Slott explained that IRAs were a good idea when they were first created. While they have more recently posed challenges regarding the taxes due on the distributions in retirement, at least beneficiaries could benefit from the stretch concept on the back end. “But now those benefits are gone,” Slott said.

In fact, Slott says that the 10-year rule is a “tax trap waiting to happen”. If forced to take required minimum distributions (RMDs), many Americans may find themselves paying taxes on those withdrawals at higher rates than they anticipated.

Now for the good news, folks – you have options available to manage these taxes if you plan early. For example, consider converting your traditional IRA to the Roth IRA. Introduced in 1997 and named after its creator, Senator William Roth, the Roth plan allows you to contribute funds on a post-tax basis – meaning you don’t get a current tax break like you do for a traditional IRA or 401(k) contribution – but the money grows tax free and you can withdraw it in retirement completely tax free (after age 59-1/2 the account has been open for at least 5 years). 

A Roth conversion isn’t painless – you will pay taxes at current income rates on any funds you recharacterize into the Roth account. However, as Slott says, “The benefit for the Roth is you know what today's rates are,” he said. “You're in control. … You avoid the uncertainty of what future higher taxes do.” If a Roth conversion makes sense for you, be sure to work closely with your financial and tax advisors on Roth conversions, since they can affect other areas of your retirement plan, including your Medicare premiums.

A couple other options to help you manage your tax bill and pass along more money to your loved ones might include switching your traditional 401(k) contributions to a Roth 401(k) to reap the same benefits as the Roth IRA. Life insurance is another wonderful asset to pass to beneficiaries, since the death benefits are passed tax free to a properly named beneficiary. 

With the Wizards in Washington continually looking for ways to levy taxes to support its inability to balance their budget, it’s crucial that we take advantage of the tax-savings strategies available to us while we can. As tax laws evolve, so should your retirement system!

And as always - be vigilant and stay alert, because you deserve more!

Have a great week.  

Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, an SEC Registered Investment Advisor with offices in Falmouth, Duxbury, and Mansfield, MA. 

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