Forbes Finance Council
Six times more people have died coming down Mount Everest than while climbing Mount Everest. The same can happen as you come down the mountain after retirement. How you distribute wealth, or “disinvest,” is even more important than how you invest. The savings decisions you are making today have far more implications than you might be seeing. Simply following “the herd” without exploring these consequences can spell trouble down the road. In some cases, the herd could be leading you right into a flooded river.
Meet the hypothetical “Alexander,” a recently retired engineer from a large utility company. He enjoyed a productive and successful career of over 40 years. He diligently saved the maximum he could each year into his 401(k) plan. He also was entitled to a pension, grandfathered with more generous interest rate schedules, that provided 75% of his highest income through retirement. He now makes over $220,000 a year during retirement, not including Social Security. His final salary before retirement was his peak income year, which was just shy of $190,000 in 2014.
ou can see that Alexander is a dedicated saver. However, the decisions he made as to where to put his savings has created a significant problem: a tax problem.
He chose to save the maximum allowable contributions into his retirement plans offered through his work because “that’s what everyone does.” “Put the maximum contribution you can into your 401(k) plan, if you can afford it!” is what he heard all through his work life.
Many people choose this route to save money because they are following “the herd.” However, this concentrated savings into tax-deferred programs creates a pool of money so large it can put you at risk of paying more taxes later in life.
ou see, when the 401(k) was added to the IRS Code in the early 1980s, tax brackets were much different, pensions were still a commonplace way to retire, and the plan was originally designed as a supplemental form of retirement savings. The 401(k) plan was not designed to be your only source of retirement savings.
To clarify, let’s take a deeper look at Alexander’s situation:
- His pension is considered qualified money, meaning it has not been taxed as income yet. His pension income during retirement puts his total earnings at a level that his Social Security benefit is also taxable as income. It also means his wife’s Social Security benefit is also taxed as income.
- Because Alexander is 71, he is subject to Required Minimum Distributions (RMDs). This is a formula requiring that you withdraw a minimum amount out of your qualified accounts. Why? Because you and your employer have deferred paying income tax and the IRS would like its revenue from that money. So, it requires you distribute from those qualified accounts or face a stiff penalty of 50%.
- His pension pays out $142,106 per year. His RMD for 2016 was $79,457. If you add in his and his wife’s Social Security benefits, their income was almost $285,000. His wife is still only 64. However, she will be subject to RMDs when she turns 70 ½ years old, which will only add more taxable income.
In short, Alexander deferred tax earlier in life – when he and his wife were in lower tax brackets – only to pay them at higher tax brackets in retirement. He is also now subject to Alternative Minimum Tax, another very costly income-based taxation. He has no mortgage, as he was told early in life to pay off his home. So, he has no mortgage interest to deduct. His two children are grown and are no longer dependents he can write off as tax credits. He also can’t contribute to qualified plans anymore, because he’s retired. He doesn’t have any income tax relief today, compared to the tax deductions and credits that helped him earlier in life.
This situation is caused by a bigger root problem: People confuse tax deferral with tax exemption. When you use qualified plans like 401(k)s at work, you are deferring tax. You are not exempt from the income tax. Keep in mind that you will pay income tax during retirement on the entire balance in your qualified plans, which is your principal and any investment gains. If tax brackets rise or if the RMD formula becomes less friendly to retirees, this exacerbates the problem even more.
This issue refers to something I call your “lifetime income tax liability.” The more you have in qualified plans, the bigger your lifetime income tax liability becomes. You must pay income taxes on that entire balance during your lifetime. If you don’t, that income tax transfers to your beneficiaries, who then must pay income taxes on your qualified plan balances at their tax brackets and with even more restrictions than you face.
By following the herd and just doing what everyone else does, Alexander put at risk tens of thousands of dollars of additional income tax that could have been shifted or more efficiently paid. His solution now? Adjust the speed at which he withdraws from his qualified assets during retirement and implement more income tax-free solutions to reduce his lifetime income tax liability by a significant amount.
The lesson to be learned here is that thoughtful estate and tax planning should be a part of your investment planning. Disinvesting should be a major consideration during the years you are saving and investing if you don’t want to end up like Alexander. The problems he faces now could have been offset earlier in life, and although he has a solution today, it is much costlier than it needed to be.
Sometimes, the herd leads you into a flooded river. Make sure you bring a life jacket.
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