If you’ve ever wasted time watching the financial news shows, you’re likely inundated with investments risks revolving around the economy, stock market, or political events. Although these risks could happen, there’s a risk to your IRA & 401k that is certain.
Here are the Top 10 tax risks to your IRA & 401k:
Everyone knows an IRA/401k receives a tax deduction on the contribution in exchange for paying taxes later. But IRA distributions can be triple taxed later with:
- Federal taxes
- State taxes apply (in all but seven states)1
- Traditional IRA's can cause taxes to apply on Social Security benefits that would otherwise not apply if you took distributions from a Roth IRA
Your IRA distributions increase as you age courtesy of Required Minimum Distributions (RMD) which start age 70 ½. Assuming a 5% rate of return, your RMDs increase each year, thus increasing your taxable income. Around age 75, the RMD’s will overpower the rate of return actually lowering your IRA balance. However, upon further inspection, you’ll see RMD’s and taxes continue to increase until your mid 90’s. What a rotten deal seeing your taxes increase while your IRA balances decrease. That is why I call the IRA “the IRS’s Retirement Annuity”. Think about it, the IRS gets a guaranteed stream of income for the rest of your life.
Your “business partner”, Congress, can change the rules without your agreement. An age-old adage says your taxes will be lower in retirement. But is this true? Often while working you claimed your children as exemptions on your tax return, deducted the interest on your home, deducted business/work expenses and of course – deducted your contributions to your 401k or IRA. In retirement you are left with little or no tax deductions: the kids are gone; the house is paid off, or payment is mostly principle. But the worst of it is if Congress mismanages fiscal responsibility they can just vote themselves a tax hike.
The dirty four-letter word is MATH. On-Page 1 of David McKnight’s book The Power of Zero, How to Get into the 0% tax bracket and transform your retirement: David M Walker appeared on national radio and made a grim prognostication: “Based on the current fiscal path, future tax rates will have to double, or our country could go bankrupt."2 This is beyond politics. Whether Democrat, Libertarian, or Republican whomever the future president is, they will inherit this math problem.
5. A False Sense of Security
One of the first things I consult a new client regarding is how misleading your IRA statements are. You simply feel better seeing $750,000 printed as the account value on your investment statement. But if I could pass a regulation, I would require IRA statements to read: Out of $750,000- your share is $525,000 and $225,000 is an unpaid loan to the IRS (assuming today’s tax rates, future tax rates can increase). By the way, you as the account holder assumes all market risk, and payment of the investment fees to grow both your share and THE(IRS).
6. The IRS Knows
Every May a 5498 form is mailed to you. It has nothing to do with filing your taxes and it simply states your year-end account balance. Why is this necessary? And why in May when you can see your balance on your December statement? Because the IRS gets a copy of the 5498. They are tracking every dollar on every American that has chosen to defer taxes into retirement. The reason is simple. They know there are future tax dollars in your IRA that is THE(IRS). In short, they look at your IRA/401k as an asset.
7. Growth Tax
Even if you received a 30% tax deduction when funding your IRA/401k and you’re in the same 30% tax bracket in retirement it’s still taxed much more due to growth. At a 7% rate of return, your money doubles every ten years. Let’s assume you saved $30,000 tax-deferred in the first part of your career. You would have saved $10,000 off your taxes. At 7%, ten years later the account would be $60,000, another ten more years would make it $120,000. 30% taxes on $120,000 is $36,000 which is 3 ½ times the taxes you saved at funding.
8. Lack of Guidance
The vast majority of investment advisor & financial planners do little to advise on taxes. Read the fine print on your investment statements. You might be surprised to find something like this: “your investment advisor is not a tax advisor. All decisions regarding the tax implications of your investments should be made in consultation with your independent tax advisor.” This puts many retirees at risk as taxes are often one of the greatest expenses in retirement.
9. Inherited Taxes
If you’re fortunate enough to outlive your IRA, your heirs inherit the unpaid tax bill. If your heirs are your adult children, and you’ve been blessed to have successful children, they may be paying taxes at an even higher rate than your own.
10. Lack of Tax Diversification
Too many times I see baby boomers nearing retirement with the vast majority of their investments in tax-deferred accounts. This leaves little room for tax diversification and restricts high expenditures in a given year as being too cost-prohibitive.
2. Copyright 2013, 2018 David McKnight
This content is developed from sources believed to be providing accurate information, and provided by Nathan Wilson of GuideSpring Wealth Strategies. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.