The Ripple Effect—The Side of 401ks, 403bs and IRAs No One Talks About

By: Kristina K. Bolhouse, CPA/PFS, CFP®

I often hear financial authors and radio personalities talk about all of the virtues of putting money into tax deferred accounts. The impact sounds so promising, and even CPAs sometimes get confused by the semantics (such as using the term “tax free growth”) when referring to 401ks, 403bs, SEP accounts and IRAs. These accounts are collectively referred to as “qualified” plans, because they qualify for certain tax benefits—namely the ability to defer income taxes. We remember the terms “before tax contributions” or “tax deductible” (for SEPs and certain IRAs), but forget the tax impact these accounts will have down the road when distributions are made.

To illustrate, let’s say you put money into a qualified plan and it grows over 20 or 30 years. At age 59 and ½, you decide you are going to withdraw $10,000 to pay for some major home maintenance. Assuming you are in the 28% Federal tax bracket and 7% state bracket, you will also need to take money out to pay for the taxes plus some additional funds to pay taxes on the taxes. See how ugly this can get? So, your $10,000 expense now requires almost $16,000 of withdrawals in retirement.

To make matters worse, for people receiving Social Security benefits, those benefits are taxable only over certain income levels. Taxpayers who have high levels of assets OUTSIDE of qualified plans have a much better shot at avoiding taxes on Social Security benefits. Once you are taking large taxable IRA withdrawals, up to 85% of Social Security becomes subject to taxes.

Medicare premiums are now also determined based on adjusted gross income. This has especially impacted our clients who are over age 70 and ½ that have required minimum distributions (RMD) where certain amounts must be withdrawn from IRAs. We noticed for our clients in their 80s and early 90s, the RMDs tend to get pretty large, making “managing taxes” virtually impossible. The ripple effect of “pre-tax” dollars put away in earlier years now has painful side effects.

So what is our recommendation? To the extent possible, we recommend putting money aside in non-qualified funds along with qualified savings. For certain, we recommend contributing to a qualified plan so that you receive any employer matching contributions. If you can put in the annual maximum amount, that is even better. Beyond that, having a monthly draft into a non-qualified investment account makes very good sense long term. The more favorable capital gains treatment is available on the growth of those assets, which means a top 20% tax rate under current law. Certain assets can also be invested tax-free—such as a state municipal bond. A million dollars in a non-qualified account is ultimately worth much more than a million dollars in an IRA, the latter having never been taxed. In summary, having a mix of qualified and non-qualified accounts in retirement gives retirees a greater ability to manage taxes and enhance long term savings.

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