“You've saved like crazy in your tax-deferred accounts, but all that money isn't really yours. Some of it belongs to Uncle Sam, and in the future he may be hungry for more. Here are two strategies to curb your future tax bill.”
“Your 401(k), 403(b) and IRA: Tax Shelter or Tax Nightmare?” This is the title of a recent Kiplinger article that looks at the fiscal challenges facing our country. Since last year, nearly every tax dollar that comes into the U.S. Treasury goes to pay for just four programs: Social Security, Medicare, Medicaid and interest on the national debt.
With more Baby Boomers retiring every day, they won’t be putting money into Social Security and Medicare. Instead, they’ll start taking money out. When they do, the costs for these four programs will skyrocket.
In the last several years, the percentage of tax dollars going to Medicare and Medicaid has increased. In 2016, 29.1% of every tax dollar went to cover health programs (such as Medicare and Medicaid), as opposed to just 20% of every tax dollar in 2012. Let’s look at where you may see changes and need to plan ahead.
Tax-Deferred Savings. Many retirees and pre-retirees have the majority of their savings in 401(k) and IRAs. Traditional accounts typically haven’t paid taxes. If you have the majority of your savings in one of those retirement accounts, remember that not all of that money is yours. The federal government can increase its share and reduce yours with new legislation in the tax code. Here are a few other things that the withdrawals from your 401(k), 403(b) and IRA accounts can impact:
- The government will tax every dollar that comes out at your highest tax bracket;
- Each distribution has the potential to move you into the higher tax bracket;
- Every dollar you withdraw may increase the tax you pay on your Social Security; and
- Each distribution can increase your exposure to the 3.8% surtax on investment income.
This means that you may need to include more of your Social Security benefits as taxable income, and your Medicare Part B premiums can increase. You also will have required minimum distributions, or RMDs, that begin at 70½. There are major penalties if you forget to withdraw funds.
Roth IRA Conversion as a Tax-Reduction Strategy. If you convert to a Roth IRA, you may protect your savings from a future tax increase by paying tax at today’s rates. With a Roth IRA, the distributions in retirement are tax-free (if you’re at least 59½ and have held your Roth account for at least five years). Therefore, they typically won’t impact other things tied to your income, such as taxable Social Security income and your Medicare Part B premiums or health insurance subsidies.
Roth IRAs also don’t have required minimum distributions during your lifetime. In retirement, you can take as much or as little as you want—you’re not forced to take anything at 70½ like with traditional IRAs or 401(k) plans. Your Roth IRA can continue to grow, tax-free, for your heirs. This a great vehicle for estate planning.
Reference: Kiplinger (May 2017) “Your 401(k), 403(b) and IRA: Tax Shelter or Tax Nightmare?”