Tax Deferred Accounts - can you have too much of a good thing?

Where to put the money you save? Well that's easy - tax-deferred retirement accounts, of course. The media (and most advisors) love tax deferred retirement accounts such as the 401k account your employer offers, or the traditional IRA. You put pre-tax money in and it grows without being taxed each year by the IRS. This is the government's way of encouraging your to save for your own retirement. But is it the best way?

The basic idea behind all these accounts is that since the money grows without taxes being taken out each year, there is more of it to compound over time so you end up with more.  Plus, you should be in a lower tax bracket when it is time to withdraw the money, so you will pay less in taxes. Sound familiar?

The first important thing to remember is that the tax is only deferred, and not eliminated. At some point you will have to pay it. So when you look at your next 401k statement, know that the government is looking over your shoulder and will take a good slice of that money. If your account balance says $300,000, try thinking of it as $200,000 because that's more like what you will be getting after taxes.

Now regarding this assumption that your taxes will be lower in retirement - is this really true? Shouldn't you hope that your net income doesn't change much? This is certainly the goal of the consumption smoothing methodology we practice at Bay Area Planners. Think about the IRS tax brackets. There's not much difference between the 28% and 25% rates, and you would have to get your taxable income down a long way to get into the 15% bracket. Could be all that happens is you move from the upper part of the 25% bracket to the lower part, and don't get any reduction. As you lose the mortgage interest deduction by paying off the house, your taxable income might not change at all. And worst of all, consider that tax rates right now are at multi-year lows, and as we will see when we talk about the issues facing the nation paying for Social Security and Medicare, it could well be that your taxes will be higher when you retire, not lower!

Another big concern is that withdrawing retirement income from these tax-deferred accounts will trigger taxation of your Social Security benefits. Up to 85% of these benefits could be subject to taxation. Taxes are the big enemy of retirement income, and as you now see, tax deferred accounts by themselves don't necessarily solve this problem.

What can you do? Well, let's take a look at what it would take to pay minimal taxes. First you must be in the 15% tax bracket (or lower), second your Social Security income mustn't be taxed. To do this, you have to get your taxable income way down. You can do this while maintaining your living standard if you also have non-taxable income to provide the balance of your consumption needs. You need the flexibility of diversified sources of income, some taxable and some not subject to tax.

Unfortunately, the non-taxable type of income isn't appreciated enough by the media, so most people don't have enough. At Bay Area Planners, we pay attention to after-tax balances - for example, when evaluating asset allocation models. We encourage the use of the Roth IRA, Roth 401k, and after-tax savings to create the correct balance for your future income. It's possible to move money from a traditional IRA to a Roth IRA by paying the taxes now. So with some forethought and planning, the situation can be optimized.

The key take-away is that reducing taxes is an important part of retirement planning, and just putting money in a tax deferred retirement savings account doesn't necessarily cut it. '

To talk to us about how our planning can increase your retirement income, call (408) 725-7135, or click here.

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