Thirty-Six Trillion Reasons to Consider Tax Planning for Your Retirement
The Federal Deficit just passed $36 Trillion! The interest alone on this debt is now larger than our defense budget. This, combined with the current cost of Social Security, Medicare, and Medicaid, makes up over 96% of the annual tax revenue. That leaves less than 4% to cover all the other items in the federal budget. The underfunded entitlement programs of Social Security, Medicare, and Medicaid are projected to be broke by 2032 and 2033, requiring reductions in the benefits paid.
Experts like David Walker, Forbes Magazine, and the Congressional Budget Office all agree that absent a significant reduction in the size and scope of these programs, tax rates must be increased significantly—perhaps even doubling—for the government to make ends meet on its budget liabilities. Finally, a recent Penn Wharton study predicts 2042 as the financial Armageddon day, the point at which no amount of spending cuts and tax increases can prevent the government from defaulting on the debt.
There are primarily four potential solutions, or combination of these four, to this crisis:
Cut Spending – Congress never wants to pursue this option. Reducing the amount of increase in their budget is what they consider a spending cut.
Borrow the money—increased interest rates and a reduction in our country’s credit rating make this less attractive than in past years when interest rates remained at historic near-zero levels.
Print More Money—We have experienced first-hand the results of this solution—the stealth tax of inflation. This only helps the bankers and the government and can devastate retirees living on a fixed income.
Raise Taxes – the only lever left absent action on the above options, particularly spending cuts. When this option is implemented, the middle class is the most highly impacted. There are not enough “rich” taxpayers to solve the problem, and the poor have nothing to tax.
This reality changes the paradigm with respect to tax planning for retirement. The old paradigm suggested you would need less income in retirement and you would be in a lower tax bracket. These two assumptions led to recommendations to use tax-deferred retirement accounts like 401k’s, 403b’s, and IRAs. You would receive a tax deduction at a higher tax rate for your contributions, your funds would grow tax-deferred, and then you would be in a lower tax bracket when you withdrew the funds in retirement. This made mathematical sense at the time.
However, things have changed since we began saving for retirement. The new paradigm suggests that you may need as much money or more in retirement as you did while working. My wife Judi and I would like to spend more money in retirement, traveling, and checking off items on our bucket list. And because of the fiscal challenges outlined above, tax rates will most likely have to be higher when you retire. This completely reverses the previous recommendation; now it makes mathematical sense to place your retirement savings into tax-free accounts like 401k Roth, 403b Roth, and Roth IRA. You would pay taxes on your contributions at historically lower rates, and your funds would grow tax-deferred and could then be withdrawn tax-free in retirement. This would eliminate tax rate risk for you, your spouse, and your beneficiaries. If the tax rates are doubled, you are still at a 0% tax rate because 2 times 0% is still 0%.
But what about all the retirement savings made under the old paradigm? Good question! Roth Conversions will become your new best friend in retirement planning. A Roth Conversions allows you to convert funds from a Traditional Tax Deferred Account like a 401k, 403b, or IRA to a Tax-Free Account like a 401k Roth, 403b Roth, or Roth IRA. The catch? You must be willing to pay the taxes on any amounts you convert. This can be a tough pill for many to swallow, but in the long run, you and your heirs will end up with more money! And isn’t that the name of the game? It’s not how much you have in your retirement accounts; it’s how much you get to keep when you withdraw the funds.
There are two guiding principles to keep in mind when considering Roth Conversion:
Tax Bracket Management – you don’t want to convert an amount in any given year that pushes you into a tax bracket that gives you heartburn. We would suggest staying at or below the 24% bracket. You want to make sure that the custodian of your account allows Piece Meal Internal Roth Conversions. This means you have the flexibility to convert any amount you choose each year, and you are not forced to convert the entire balance in one year.
Source of Funds to Pay the Taxes – There are three primary sources of funds to pay the taxes on your conversion. The first and best source would be non-retirement accounts like savings and money markets. The second source would be to increase your withholding on your earned income to ensure you have enough additional funds to pay the tax on the conversion. The final and least efficient source would be to withhold the taxes from the conversion. This option would normally only be applicable to someone who is older than 59.5 to avoid the 10% penalty for early withdrawal. It also represents a very inefficient choice as you are forever foregoing potential future tax-free funds.
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