ANCHORAGE, AK / ACCESSWIRE / July 27, 2020 / You are probably borrowing money from the IRS on a regular basis and don’t even realize it. This may be creating a series of retirement tax time bombs that could have been avoided. Don’t wait until it is too late to do something about this problem affecting millions of Americans.
Are you contributing to a tax-qualified plan, like an IRA or 401(k), as a way to save for retirement? Millions of Americans are, every pay day. Did you realize that you’re taking a small loan from the IRS each time you contribute to your IRA or 401K? This is slowly and steadily creating several ticking tax time bombs for you, just waiting to go off in retirement, or sooner in some cases. If you’re tired of borrowing from the IRS and don’t want the burden of a tax lien on your retirement accounts, read on.
Your Tax Deductions are a Loan
Here’s a secret. Those tax ‘deductions’ you take today aren’t truly deductions. They are an advance on your retirement funds that you’ll repay during retirement and then some. In short, it’s basically a loan you take from the IRS each pay period that you have to repay when you retire – a time in your life when you need the most money possible.
Americans love instant gratification, like tax deductions. Even if it hurts them in the long run, or isn’t in their best interest, they want everything now. This is evident by the overuse of credit cards, payday loans, and 2-hour delivery from Amazon. This is also evident when you look at utilization rates of the Traditional IRA and 401(k) in comparison to the Roth IRA and Roth 401(k).
When you take the deduction on your retirement contributions, you lower your tax liability today but increase it in the future. That instant gratification feels great, a little more money in your pocket now, but it may not be in your best interest in the long run. Once you retire, and you want to spend that money you worked so hard to save, you’ll have to pay back all of those tax deductions you ever received, plus more. Even if you don’t want to spend your money once you get older, the government is going to force you to. At age 72, you don’t have a choice, you will be subject to something called RMDs (required minimum distributions). If you have money in tax-deferred plans, you must start to withdraw that money and pay the taxes (the loan back). You pay taxes not only on the original contributions that you received a deduction on, but on all the earnings and growth too. Paying taxes on all the growth in your account is just like paying interest on those original deductions.
And if life happens along the way and you don’t keep the loan going from the IRS till the magical age of at least 59.5 years old, you may also have to pay a 10% penalty on those funds on top of the taxes. But wait, the tax time bomb gets even worse.
The Social Security Tax Problem
Only one part of the tax time bomb goes off when you first retire. You start paying taxes on all that money you saved and realize that you have much less in savings than you thought. This is because a good chunk of your retirement account actually belongs to the IRS. The second part of the tax time bomb goes off when you do your taxes for the first time once you have started your Social Security income. Many people don’t realize until it is too late to do anything about it that their IRA or 401K may also cause issues with their Social Security income. According to the Social Security Administration, about 56% of families will owe federal income tax on their benefits from 2015 through 2050.
Depending on whether you are single or married, there is a limit on the amount of income you can take in retirement before your Social Security starts getting taxed. Meaning, if you take money out of your Traditional IRA or 401(k) in retirement, above the thresholds set by the IRS, you will not only owe taxes on the money you withdrew, you may also owe taxes on up to 85% of your Social Security. The thresholds are not that high either. Here is how it works…
Take your adjusted gross income + any non-taxable interest you earn + half of your social security benefit and add it all up.
In 2020, if you are single, and that calculation is greater than $25K, you will owe taxes on your Social Security. Married couples start paying taxes on Social Security once that calculation reaches $32K.
So, What’s the Answer?
If you’re tired of borrowing from the IRS, consider a Roth IRA or the Roth 401(k).
While it doesn’t have the attractive tax deductions this year, next year, or any year you make a contribution, it has tremendous tax benefits during retirement. First, you don’t pay taxes on the contributions or earnings when withdrawn in retirement if the account has been open for at least 5 years.
If that’s not enough, Roth IRA income doesn’t count toward the Social Security or the Medicare premium thresholds, saving you even more money on taxes and helping to defuse more tax time bombs. You earn Social Security income plus take your desired Roth IRA withdrawals and you don’t pay any taxes – talk about more money in your pocket.
If keeping more money for yourself and not paying the IRS isn’t enticing enough, here are a few other considerations.
Tax rates are incredibly low today. Will they stay there? The chances are slim. The low tax rates we see today are due to the Tax Cuts and Jobs Act. This Act expires in 2025. Given the spending rate thanks to COVID lately, tax rates will likely increase.
Why should you care about rising tax rates? If you contribute to a Traditional IRA or 401K, you pay taxes on your retirement withdrawals. Most people bank on the fact that they’ll be in a lower tax bracket when they retire, and they might. But if tax rates increase, you may not be in a lower tax bracket and pay more taxes than you expected. Especially if you will also have to pay taxes on your Social Security as well because of your tax-deferred withdrawals. Many people, who have planned diligently, have income in retirement similar to what they had while they were working; without the benefit of all the deductions they enjoyed, like mortgage deductions and child credits.
For some people, the tax time bomb just keeps going off. Another ‘tax’ people don’t think about until they are paying it, is Medicare premiums. Medicare premiums work a lot like Social Security taxes and increase with your income. If your income exceeds certain thresholds, you will have to pay higher Medicare premiums. High-income seniors pay hefty Medicare Part B and Part D premiums. Roth withdrawals do not count toward these thresholds, yet another reason to use the Roth IRA in your financial planning.
The Final Explosion
The final tax bomb detonation happens when the first spouse passes. This is an unfortunate time in retirement and shouldn’t come with more bad news, but it does for many. Often, the only income that passes with the first spouse is the couple’s smaller Social Security check. Thus, leaving the surviving spouse with nearly the same income and in a much higher ‘filing single’ tax situation. With the lower standard deduction and the increased tax brackets for those filing single, it can really put a widow/widower in a bad tax situation.
This is where the Roth IRA can also shed some welcome light, especially if the couple utilized the Roth in their financial planning and have minimized the tax bills in retirement. The Roth is able to be passed on to the surviving spouse (and eventually anyone) without any tax consequences. The income that is being produced by a Roth also won’t be affected by any new tax bracket the widow/widower might find themselves in.
Stop Borrowing Money from the IRS
Here’s the bottom line. Stop borrowing money from the IRS and just kicking that tax problem down the road. If you contribute to a Traditional 401K, do so only because you want the employer match. That’s like free money – no one would tell you not to take it. But stop there. If your employer now offers the Roth 401(k), switch to this option. If they match in the Roth 401(k), even better!
Any other money you contribute to your retirement funds, contribute to a Roth IRA. You may pay taxes now because of it, but you’ll earn greater benefits when you retire, and you may be able to stay under the thresholds for Social Security tax and higher Medicare premiums later. Wouldn’t you rather have a few less dollars in your tax refund today and pay thousands of dollars less in taxes during your retirement?
Also consider lesser known strategies like the back-door Roth IRA or the Mega-Roth strategy. These may help you save even more in tax free accounts. Consider Roth conversion strategies as well but work with a qualified fiduciary financial advisor and/or tax advisor to determine if this is in your best interest before executing these strategies.
I don’t know about you, but I want to have every dollar possible when I retire. I am also patriotic, but I don’t have any desire to pay more in taxes than I am required to. You don’t know what life’s going to throw at you during those senior years. The more money you have available without tax liability, the better your chances of living the life you dreamt of living in retirement.
James Miller is the founder of Baobab Wealth and Baobab Wealth Abroad, and offers advisory services through Intervest International Inc., an SEC registered investment advisor. With 20 years of experience, Jimmy works with individuals and families to create financial plans that address their individual situations. He has a bachelor’s degree in business administration and holds the CRPC (Chartered Retirement Planning Counselor) from the College for Financial Planning. Learn more about Jimmy by connecting with him on LinkedIn.
By: James Miller, CRPC – Anchorage, AK – (907) 317-8454
SOURCE: Baobab Wealth Management
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