Would you like to pay less taxes this year? It is a trick question. A related answer is another question: Will it make me pay more taxes later? If not, then duly paying less taxes is irrational. But when paying less taxes now is just a tax deferment, the decision can be mind-blowing. It includes a comparison of the tax reduction received now and the taxes expected to be paid later. We’d rather not pay later than we’re saving now. So, before taxing the road, it’s wise to look ahead.
This is very important because the chances of tax deferrals are many. For example, retirement savings typically include tax-deferred accounts such as 401(k)s, IRAs, and 403(b)s. Although they are individual accounts, we may also think of them as joint accounts because Uncle Sam expects his share when we withdraw funds. The amount we keep depends on how good the long-term tax plan we create.
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Tax aversion may force retired savers to defer all taxes they can, year after year. Sometimes, this is the right thing to do. But not always.
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common examples
A common assumption that justifies a retirement tax deferral is that we will be in lower tax brackets in retirement than in our years. It is a general assumption that is not always true. While we’re saving for retirement, we may be in a lower tax bracket because of the mortgage interest deduction, the benefit of having dependents, and filing for married, for example. By contrast, we may be in higher tax brackets in retirement due to the accumulation of wealth or the use of individual filing status.
When retirees have little money outside of tax-deferred accounts, exceptionally large expenses can require taxable withdrawals that step into painfully high tax brackets. Then, taxes may discourage retirees from making discretionary withdrawals they would otherwise enjoy (eg, redesign, travel list). For unavoidable expenses, withdrawals can add tax salt to the financial wound.
To make matters worse, the cost of receiving Medicare Parts B and D can increase when income rises, inflating the cost of withdrawing money from tax-deferred accounts.
Deferring distributions from tax-deferred retirement accounts can build a tax trap. In general, distributions can be taken without penalty starting at age 59½ and must be taken annually starting at age 72. These are the notoriously required minimum distributions, or RMDs. One of the many tax law exceptions allows employees to defer RMDs beyond age 72 if they continue to work, among other requirements. So, I once met an employee in his 80s who deferred distributions for so long that he couldn’t bring himself to retire and pay very high taxes on RMDs for his 401(k) account. Deferring taxes can deter retirement!
It’s a rare situation, and the moral of the story is not to avoid tax deferrals. not at all. The lesson is to start early on a long-term tax plan.
How to avoid falling into the retirement tax trap
Drawing: How to Avoid Building a Tax Trap
Make long-term tax planning the focus of your financial plan. For example, estimate the size and sources of your retirement income. Plan his timing and consider retirement income tax strategies, such as opportunistic Roth transfers.
Consider your savings options. For example, if your job offers a tax-free Roth 401(k), is this a good option for you? Should You Contribute to a Traditional IRA or a Roth IRA? Would a taxable account be useful as part of your savings mix? Do you qualify for an HSA? The answer to these questions may change from year to year, so revisit them regularly.
As best you can expect, assess whether tax deferral makes sense for your unique taxes and general financial situation. For example, I once met a low-income heiress who contributed to a 401(k). Once she receives her inheritance, she is supposed to be in a much higher tax bracket for life. Then, taxes on distributions from your 401(k) will cost more than the interest you initially received for the contributions.
Alleviate uncertainty with flexibility. Choices are nice because life is full of surprises, welcome or not. As such, it pays to have various resources for managing taxes along the twists and turns of retirement. For example, to pay for unusually large expenses, it may be worth taking advantage of tax-exempt funds, such as a Roth IRA. By contrast, some retirees may need to increase their taxable distributions in order to fully use unusually high tax credits and deductions (such as the EV credit, medical expenses).
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Tax law is full of give and take. Of course, it takes most of the time. When we get a tax exemption, it is important to know if we are expected to return it. Modern retirement, with its array of tax-benefit accounts, confronts us with many decisions: how much to save, which account(s) to fund, and which investments to choose. but that is not all. Retirement will require us to take the money. That’s the point, isn’t it? We must then also plan to avoid falling into a tax trap, have a long-term plan for the distribution of taxes, and make the most of what we spend.
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Editor’s note: This article is intended for general information and educational purposes only and is not intended to be specific financial, accounting, legal or tax advice. Individuals should speak with qualified professionals based on their circumstances. The analysis in this article may be based on third party information and may become outdated or replaced without notice.
Content reviewed for tax accuracy by a TurboTax CPA expert.
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