Financial advisers consistently caution savers about the dangers of stockpiling too much of their retirement money in tax-deferred investment plans. Do a quick online search of the term "ticking tax time bomb," and you'll see that advice goes back at least a decade.
There are benefits to these popular investment accounts. The automatic payroll deductions are convenient, and workplace plans often come with some percentage of employer match. Those are pretty nice perks. Plus -- and this can be a big plus -- every dollar you contribute to your 401(k) , 403(b) , SEP IRA , etc., is one less dollar on which you'll have to pay income tax that year.
But, of course, a day of reckoning is coming. When you retire, you'll pay taxes on every dollar you withdraw from those accounts. If your tax-deferred savings are a large part of your retirement income plan, the tax bill that awaits you could be substantial.
And yet, convincing investors that paying a little more in taxes today will save them down the road is a tough sell. Changing their ways will take some effort on their part, not to mention some money upfront, they tell us, so they want an incentive.
The tax reforms passed in 2017 could provide that push.
Effect of Lower Tax Rates Now
The Tax Cuts and Jobs Act puts many people into a lower tax bracket starting this year and for at least the next few years. That means wise savers have an opportunity to move a little or a lot of their pretax dollars to a Roth account or a life insurance policy with potentially tax-free withdrawals, pay the taxes now, and avoid what could be much higher rates in the future. Unlike with 401(k)s and traditional IRAs , with a Roth IRA , you never pay taxes on your qualified withdrawals, and your money grows tax-free as well.
Life insurance policies, when properly structured and funded, can work similar to a Roth and are not qualified -- meaning contribution amounts can be much higher. In addition, life insurance can create income tax-free death benefits for your spouse or beneficiaries, as well as tax-free withdrawals (typically via policy loans) for long-term care or other retirement needs.
With the use of these tools, today's relatively low tax brackets can help greatly reduce, and could possibly eliminate, future income tax payments and the effects of future tax bracket increases.
I know, conventional wisdom is that everyone's taxes are lower in retirement. We've all been told we'll need less money and, therefore, require less income. But there are all kinds of problems with that theory. Unless you're planning to completely downsize your lifestyle -- not just your home, but your car, your hobbies, your wardrobe, your meals, etc. -- your expenses won't necessarily be reduced.
Many people hope to stay active and actually do more in retirement, at least in the early years. In fact, I find that most retirees travel more in the first five to 15 years of retirement than any other time in their lives. When you do slow down a bit, there often are health care costs. And some big money-saving tax deductions go away when you pay off your house or lose a spouse.
Future Tax Rates in Question
Beyond all that, though, there's the very real threat that tax rates could go up significantly in the future. Just as with the recent reduction in tax rates, you can expect politics to play a role in any increase. Here's why:
- The government will not let Social Security fail. Let's face it: The over-50 population would implode -- and those people vote. The Congressional Budget Office's 2016 long-term projections for Social Security stated that " under current law , CBO projects, Social Security's trust funds, considered together, will be exhausted in 2029. In that case, benefits in 2030 would need to be reduced by 29 percent from the scheduled amounts." To keep voters happy, politicians may not only increase FICA taxes on wage earners, but also increase general taxes to protect promised benefits.
- Our $21 trillion national debt is getting bigger every day. In May, The Wall Street Journal reported that forecasters it surveyed "increasingly expect four Federal Reserve rate increases in 2018." Who pays the rising interest on our nation's growing debt? Our government. (And that means the taxpayers.)
- We're living longer, but not necessarily healthier, lives. Social Security isn't the only fund facing a daunting demand. In June, program trustees reported that Medicare, which serves about 60 million people, will become insolvent in 2026 -- three years earlier than previously forecast. As health care costs increase for an aging population, the government will need more tax money if it's going to continue to fund Medicare and Medicaid.
We all complain about taxes now, but imagine what it could be like in the future if the government finally decides to play catch-up on its debts and obligations.
The current top rate is 37% for those whose taxable income is over $500,000 (individuals) or $600,000 (married filing jointly). For the middle two brackets, the current rates are 22% and 24%. Historically, rates have been much higher. In 1944, the top federal rate peaked at 94%. And in the '50s, '60s and '70s, the top rate remained high, never dropping below 70% .
What Retirement Savers May Want to Consider Doing Now
If that isn't incentive enough to reposition a portion of your nest egg ASAP, I'm not sure what is. Alternatively, consider:
- Contributing to a Roth instead of a tax-deductible retirement account for married couples with incomes of up to $339,000 who are using the $24,000 standard deduction (putting them at the upper limit of the 24% tax bracket). Couples with incomes above $339,000 should have a tax professional run the numbers.
- Contributing to regular tax-deductible retirement accounts and using the " backdoor Roth " strategy to convert to a Roth. Note that there are additional restrictions to consider before implementing this strategy.
- Rolling over tax-deductible accounts into a Roth. In my opinion, this should be spread over a maximum of the next eight tax return years up to at least your 24% tax bracket.
- With the use of professional advice from a CFP® or other qualified financial planner and a qualified tax adviser, starting a maximum seven-year life insurance contribution plan. This plan should meet all the IRS MEC avoidance guidelines with maximum contributions and minimum death benefits with the potential for tax-free income via policy loans starting in year eight or later.
You can wait until 2025, when the new tax rates are set to expire. (Although, if there's a change in administration, that window could grow smaller.) Or you could make things a bit easier on your pocketbook and convert a little each year for the next few years. But now is the time to talk to your financial adviser and tax accountant about what converting tax-deferred dollars to after-tax dollars could mean to you.
Find out if it makes sense to start defusing your potential "tax time bomb."
Kim Franke-Folstad contributed to this article.
It's important to remember that most life insurance policies are subject to medical underwriting, and in some cases, financial underwriting, and the costs of a life insurance policy is dependent on your age and health at the time of application. Life insurance products contain fees, such as mortality and expense charges, and may contain restrictions, such as surrender charges. If properly structured, proceeds from life insurance are generally income tax-free.
Policy loans and withdrawals will reduce available cash values and death benefits and may cause the policy to lapse, or affect guarantees against lapse. Additional premium payments may be required to keep the policy in force. In the event of a lapse, outstanding policy loans in excess of unrecovered cost basis will be subject to ordinary income tax. Tax laws are subject to change and you should consult a tax professional.
Neither the firm nor its agents or representatives may give tax or legal advice. Individuals should consult with a qualified professional for guidance before making any purchasing decisions. Investment advisory services offered through Blue Ridge Wealth Planners, a Registered Investment Advisor. Securities offered through Madison Avenue Securities, LLC (MAS), member FINRA/SIPC. MAS and Blue Ridge Wealth Planners are not affiliated companies.
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