Tax-Deferred Accounts are Valuable – If They aren’t Your Sole Savings Strategy

Why diversification is critical for retirement accounts

It sounds like a no-brainer for tax planning: defer as much income as you can from a current high-tax bracket to a time you are likely to be in a lower tax bracket, such as retirement. Tax-deferred accounts can be a valuable vehicle for tax-efficient retirement savings, especially for high-income earners. But there are several reasons this strategy can backfire – and these should be carefully considered before you automatically sock all your money into these plans for your golden years.

What is a tax-deferred account?

The majority of tax-deferred accounts (TDA) offer immediate tax deductions on the full amount of your contributions and enable investment earnings – including interest, dividends, and capital gains – to accumulate tax-free. Future withdrawals are usually taxed at ordinary income rates.

Let’s break down what that means: Say your current taxable income is $100,000 and you contribute $5,000 to a TDA. You will only pay tax this year on $95,000. But once you retire, if your taxable income is $50,000 and you decide to withdraw $5,000 from your TDA, you will pay taxes on $55,000.

What are the different types?

Tax-deferred accounts can be qualified – meaning contributions are made on a pre-tax basis – or non-qualified, meaning contributions are made from post-tax income but earnings can still accumulate tax-free until they are withdrawn. While many qualified plans limit annual contributions, many non-qualified ones do not. Some examples include:

• Permanent life insurance. Not only can cash grow tax-deferred inside the policy, but you can transfer your assets income-tax and estate tax-free to beneficiaries.
• Deferred annuities. Tax is deferred on your gains until you withdraw them from the contract, and only the earnings are taxable.
• Employer-sponsored retirement plans, including 401(k), 457, or 403(b)s. Employees allocate a percentage of their pre-tax salary to one or more investment accounts, where it accumulates tax-free. Distributions are taxed at ordinary income rates once you reach retirement age, and penalties are usually assessed to earlier withdrawals.
• Traditional IRAs and Roth IRAs. Traditional IRAs function similarly to employer-sponsored retirement plans. Contributions to Roth IRAs are taxed but distributions are tax-free once you reach retirement age, including investment growth. You can also withdraw contributions at any time without a penalty.
• Health Savings Accounts (HSAs). Besides providing tax-deferred growth of earnings, HSAs are also tax-free if withdrawals are used to pay for qualified medical expenses.

Until when is tax deferred?

Ideally, the income is not taxed until retirement, when your tax bracket is likely to be lower. But even if your bracket stays the same, you can still benefit from a tax-deferred account because it’s almost always better to pay taxes in the future and save and invest the money you earn now.

So what’s the down side?

• Withdrawals can impact your tax bracket. Withdrawing money from tax-deferred accounts can bump you into a higher tax bracket in the year that you use it. This is especially true if your plan requires you to start taking minimum distributions at a certain age.

Consider this: $38,700 in income places single retirees in the 12 percent tax bracket in 2018. But earning a dollar more bumps you up to 22 percent. Too much saved in tax-deferred accounts can leave you with little flexibility and an unexpectedly big tax bill in retirement.

• Withdrawals can impact Social Security taxation. There is a formula that determines how much of your Social Security is taxed, and a major factor is the amount of “other income” you receive. Withdrawals from TDAs can make more of your Social Security income subject to taxation. Medicare premiums can also go up because they are linked to income.
• Taxable withdrawals are taxed at ordinary income rates. TDAs are best suited to your least tax-efficient holdings. For instance, they can prevent you from profiting off the lower tax rates that usually apply to qualified corporate dividends or long-term capital gains. For the 2018 year, you do not need to pay taxes on qualified dividends if your ordinary income is $38,600 or less. If your income falls between $38,600 and $425,800, you pay a tax rate of 15 percent.
• There’s no step-up basis at death. Most assets qualify for step-up basis at death, which eliminates or minimizes capital gains tax by “stepping up” the value of an appreciated asset for tax purposes to its fair-market value at the time it’s inherited. This doesn’t apply to most TDAs, causing your beneficiary to pay ordinary income tax on any distributions at his or her regular tax rate.
• Withdrawals can be subject to a penalty tax. If you need money before you retire, many tax-deferred accounts will force you to pay penalties and taxes on the withdrawal.

What does this mean for you?

Just like diversification is important for investments, spreading your money across diverse tax buckets is the best way to reduce your long-term tax bill. Rather than funneling all your funds into tax-deferred accounts, it’s also wise to build up after-tax accounts that you can withdraw from during retirement.

Even though you will sacrifice some deductions now, the financial flexibility you create will be invaluable in your golden years. A qualified certified public accountant can help you estimate your future tax bracket and determine the right balance of accounts to set you on the path toward a comfortable retirement.

Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact in their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create tax-free wealth for life. Contact us for expert advice on tax planning, and to find out how we can help your business exceed your expectations.