Trouble Ahead
TED BENNA IS OFTEN called the “father of the 401(k).” In 1980, he implemented the first 401(k) plan based on his somewhat bold interpretation of the Revenue Act of 1978. He certainly couldn’t have envisioned the $11.4 trillion in “defined contribution” 401(k) and 403(b) accounts that we have today.
Individual retirement accounts also took off in the early 1980s, and traditional IRAs now hold an additional $11.3 trillion. Combined, that’s an impressive $23 trillion in tax-deferred retirement assets. On top of that, Roth IRAs hold an additional $1.4 trillion.
The catch: Other than Roths, these accounts come with significant embedded income-tax bills. Perhaps as much as 30% of the total will eventually be paid to Uncle Sam and the 37 states that tax retirement-account distributions.
This "ticking tax bomb" is particularly onerous when the distributions are taxed at higher rates than when the original contributions were made. The risk of steep tax bills in retirement was often little discussed—if it was discussed at all—when today’s retirees started funding their 401(k)s decades ago.
Here are 10 tax-bomb realities that weren’t on my wife’s and my radar screen when we excitedly started contributing to 401(k)s and IRAs in 1982:
Our marginal federal tax rate when we take required minimum distributions (RMDs) in a few years will be higher than the rates at which we deducted our contributions during our early working years. Throughout our early working years, financial advisors regularly reassured us that “your tax rate will be lower in retirement.” We and they didn’t foresee the impact of tax-bracket creep—the rising marginal rate we’d pay as our income grew.
No early advisors recommended some balance of taxable accounts and retirement accounts. The 1980s and 1990s playbook was to max, max, max 401(k) savings.
Taxable-account investments have three advantages that don’t get enough attention. First, any appreciation is taxed as capital gains, rather than at the usually higher ordinary income-tax rate. Second, investors get to determine when to take capital gains—and potentially also offsetting losses—rather than being forced by RMD rules. Third, heirs can avoid tax on the embedded capital gains, thanks to the step-up in cost basis upon death.
RMDs can result in hefty taxes on Social Security benefits. To make matters worse, the thresholds at which Social Security gets taxed aren’t adjusted for inflation, so half of retirees now pay income tax on their benefits. Nine states also tax Social Security.
RMD income can also trigger the Medicare premium surcharge known as IRMAA, or income-related monthly adjustment amount. IRMAA now hits some 8% of Medicare recipients. The cost can be as much as $6,000 a year for individuals and $12,000 for married couples.
When retirement-account assets reach a level where future RMD income might put folks in, say, the 22% or 24% tax bracket, savers may want to back off contributions above what’s necessary to get the employer match. For married couples, the alarm bells might ring when their traditional retirement accounts reach perhaps $1 million or $2 million.
A booming stock market has made the tax bomb significantly worse. We never anticipated that the market would nearly triple in the eight years since we retired. Even more modest returns might cause retirement savings to double over the 10 or 15 years between retirement and when RMDs start.
Once RMDs begin, tax-bracket creep may continue if retirement savings grow faster than the sum that’s required to be withdrawn each year.
When the first spouse dies, the surviving spouse must take similar RMDs, but pay taxes using half the standard deduction and less generous individual tax brackets.
We funded retirement accounts for four decades assuming that our children could “stretch” withdrawals from the accounts that we’ll bequeath them over their lifetime. But that stretch was nixed by the 2019 Secure Act. Our children must now drain inherited tax-deferred accounts over 10 years, handing them additional taxable income when they’re already in their peak-earning years.
For retirees with large traditional retirement accounts, Roth conversions before RMDs begin may be the only way to defuse the tax bomb. Meanwhile, thanks to the advent of Roth 401(k)s, Roth IRAs and health savings accounts, younger generations can avoid getting ensnared in these tax-bomb traps. These younger workers should favor Roth accounts while their marginal tax rate is low, while also making the most of health savings account if they’re eligible.
Finally, we retirees should advise our children and grandchildren about the benefits of saving in all three tax buckets—taxable accounts, traditional retirement accounts and tax-free accounts. That tax diversification should help defuse the tax bomb caused by focusing too much on traditional 401(k)s and IRAs.
John Yeigh is an author, coach and youth sports advocate. His book “Win the Youth Sports Game” was published in 2021. John retired in 2017 from the oil industry, where he negotiated financial details for multi-billion-dollar international projects. Check out his earlier articles.
Individual retirement accounts also took off in the early 1980s, and traditional IRAs now hold an additional $11.3 trillion. Combined, that’s an impressive $23 trillion in tax-deferred retirement assets. On top of that, Roth IRAs hold an additional $1.4 trillion.
The catch: Other than Roths, these accounts come with significant embedded income-tax bills. Perhaps as much as 30% of the total will eventually be paid to Uncle Sam and the 37 states that tax retirement-account distributions.
This "ticking tax bomb" is particularly onerous when the distributions are taxed at higher rates than when the original contributions were made. The risk of steep tax bills in retirement was often little discussed—if it was discussed at all—when today’s retirees started funding their 401(k)s decades ago.
Here are 10 tax-bomb realities that weren’t on my wife’s and my radar screen when we excitedly started contributing to 401(k)s and IRAs in 1982:
Our marginal federal tax rate when we take required minimum distributions (RMDs) in a few years will be higher than the rates at which we deducted our contributions during our early working years. Throughout our early working years, financial advisors regularly reassured us that “your tax rate will be lower in retirement.” We and they didn’t foresee the impact of tax-bracket creep—the rising marginal rate we’d pay as our income grew.
No early advisors recommended some balance of taxable accounts and retirement accounts. The 1980s and 1990s playbook was to max, max, max 401(k) savings.
Taxable-account investments have three advantages that don’t get enough attention. First, any appreciation is taxed as capital gains, rather than at the usually higher ordinary income-tax rate. Second, investors get to determine when to take capital gains—and potentially also offsetting losses—rather than being forced by RMD rules. Third, heirs can avoid tax on the embedded capital gains, thanks to the step-up in cost basis upon death.
RMDs can result in hefty taxes on Social Security benefits. To make matters worse, the thresholds at which Social Security gets taxed aren’t adjusted for inflation, so half of retirees now pay income tax on their benefits. Nine states also tax Social Security.
RMD income can also trigger the Medicare premium surcharge known as IRMAA, or income-related monthly adjustment amount. IRMAA now hits some 8% of Medicare recipients. The cost can be as much as $6,000 a year for individuals and $12,000 for married couples.
When retirement-account assets reach a level where future RMD income might put folks in, say, the 22% or 24% tax bracket, savers may want to back off contributions above what’s necessary to get the employer match. For married couples, the alarm bells might ring when their traditional retirement accounts reach perhaps $1 million or $2 million.
A booming stock market has made the tax bomb significantly worse. We never anticipated that the market would nearly triple in the eight years since we retired. Even more modest returns might cause retirement savings to double over the 10 or 15 years between retirement and when RMDs start.
Once RMDs begin, tax-bracket creep may continue if retirement savings grow faster than the sum that’s required to be withdrawn each year.
When the first spouse dies, the surviving spouse must take similar RMDs, but pay taxes using half the standard deduction and less generous individual tax brackets.
We funded retirement accounts for four decades assuming that our children could “stretch” withdrawals from the accounts that we’ll bequeath them over their lifetime. But that stretch was nixed by the 2019 Secure Act. Our children must now drain inherited tax-deferred accounts over 10 years, handing them additional taxable income when they’re already in their peak-earning years.
For retirees with large traditional retirement accounts, Roth conversions before RMDs begin may be the only way to defuse the tax bomb. Meanwhile, thanks to the advent of Roth 401(k)s, Roth IRAs and health savings accounts, younger generations can avoid getting ensnared in these tax-bomb traps. These younger workers should favor Roth accounts while their marginal tax rate is low, while also making the most of health savings account if they’re eligible.
Finally, we retirees should advise our children and grandchildren about the benefits of saving in all three tax buckets—taxable accounts, traditional retirement accounts and tax-free accounts. That tax diversification should help defuse the tax bomb caused by focusing too much on traditional 401(k)s and IRAs.
John Yeigh is an author, coach and youth sports advocate. His book “Win the Youth Sports Game” was published in 2021. John retired in 2017 from the oil industry, where he negotiated financial details for multi-billion-dollar international projects. Check out his earlier articles.The post Trouble Ahead appeared first on HumbleDollar.
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