Throughout the past several decades, the conventional wisdom (or status quo) has taught us to put as much money as we could into traditional tax-deferred retirement vehicles such as 401k, 403b, and IRA accounts. While this is notably better than not saving at all, relying solely on these accounts may be to the detriment of many Americans saving for retirement. Much has changed over the years, but it seems much of the financial advice out there has not.
What exactly is a tax deferred retirement account?
These accounts allow contributions to be made on a pre-tax basis. This means you are able to deduct the contribution from your taxable income and defer payment of the taxes until you withdraw the money from the account. It is important to note that this is not reducing your taxes, as many financial professionals will suggest, but rather postponing the payment of these taxes to a later date at an unknown rate. The funds are also allowed to grow tax deferred until withdrawal at which point all withdrawals are considered ordinary income.
Tax deferred accounts came about in the 70’s and early 80’s when tax rates were some of the highest in history. The 401k was originally designed as a way to offer highly compensated employees the option to defer their taxes during a period of when highest marginal tax rate had never dipped below 70% for three decades. At that time, it made sense to take the deduction when taxes were high and pay the taxes later when taxes were likely to be lower. The Tax Reform Act of 1986 reduced the highest marginal rate to 28% and it has remained relatively level between 30 – 40%, since then. The current highest marginal rate as of the writing of this article is 37%. However, this rate is likely to increase with the newly proposed tax increases on household making over $400,000 or individuals making over $200,000.
So, what has changed?
It’s no secret the future of Social Security and Medicare may be in serious jeopardy without reforms and additional funding from tax revenue as pointed out in the annual Medicare and Social Security Trustee’s reports.** The national debt has skyrocketed to over 28 trillion dollars (usdebtclock.org). The former Comptroller General of the United States, David Walker, has famously said the tax rates would have to double in order continue to fund the government, and that was before the multitrillion dollar stimulus packages passed during the COVID-19 pandemic (CNN op-ed entitled Why Your Rates Could Double). With no slowing in spending in sight, tax revenue will have to increase significantly to continue to fund the government’s programs. That is not a political statement, but rather a mathematical fact. That could mean serious trouble for your retirement account.
Many financial professionals will suggest that you will be in a lower tax bracket when you retire. But is this really true? How much do you want to lower your standard of living by when you retire? For my clients, their goal is to maintain their standard of living, not reduce it. The objective should be to save enough to generate the same, or similar, income in retirement as you were making during your working years, right? And remember when you retire, every day is Saturday! In addition, when you retire it is likely you will not have some of the major deductions you had while you were working. These include deductions such as your mortgage interest deduction, dependent children, and contributions to your retirement plans. There is a real possibility that you could have less income and still be in a higher bracket without some of these deductions! And the truth is, your advisor really has no idea what tax bracket you will be in when you retire unless they can accurately predict tax laws 10, 20, 30, or more years down the road. That means you really cannot predict how much after-tax (spendable) income your 401k or IRA will generate in retirement until the day you retire. Do you really want that uncertainty in your retirement planning?
Re-thinking how you save for retirement
With the likelihood of future tax increases growing by the day, it is time to start challenging the status quo and re-thinking how you save for retirement. There is currently over 19 trillion dollars in tax deferred retirement accounts in America (statista.com), and those accounts are the low hanging fruit for the IRS to collect additional tax revenue. That means many Americans following the traditional planning strategies would have taken the tax deduction at historically low rates, postponed payment of said taxes, and now face the reality of higher rates when they withdraw their money in retirement. The good news is there are proven, innovative solutions that can help mitigate and reduce the risk of increasing taxes on your retirement accounts and give you more control of your money with more positive and predictable outcomes. Whether you are just starting to save, getting ready to retire, or anywhere in between there are steps that can be taken now to address this growing risk and build tax advantaged wealth.
About the Author: Nick Davidson, LUTCF is an advisor working to positively impact the lives of medical professionals nationwide. He has over 14 years of experience in the industry and has served as a board member for the National Association of Insurance and Financial Advisors and served 3 terms as President in the Rochester, MN location. He is also a designated representative for income protection and financial advisory needs for students in various programs at the University of Minnesota School of Medicine, School of Dentistry, School of Public Health, and school of Allied Health. Contact info Nick_Davidson@fosterklima.com, 507-990-3139.
Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). OSJ: 920 2nd Avenue South Suite 1100, Minneapolis, MN 55402, (612) 746-2200. Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is a wholly-owned subsidiary of Guardian. Foster Klima & Company is not an affiliate or subsidiary of PAS or Guardian.
This material contains the current opinions of the author but not necessarily those of Guardian or its subsidiaries and such opinions are subject to change without notice. Guardian, its subsidiaries, agents and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. The information provided is based on our general understanding of the subject matter discussed and is for informational purposes only. 2021-119582 Exp 04/23
**Trustees Summary Report: https://www.ssa.gov/oact/trsum/