3 Ways to Escape the Pitfalls of Tax Deferral

tax deferral

When it comes to planning for retirement, tax-deferred accounts are often promoted as an attractive option. The promise of deferring taxes until a later date, when your income may be lower, can be alluring. However, there are also significant downsides to this approach that should not be overlooked.

Firstly, the future tax rate is unknown and could end up being higher than it is today. This means that you could end up paying more in taxes when you withdraw your funds, thereby reducing your retirement income. Most people assume they’ll be in a lower tax bracket because typical financial talking heads throw that phrase around. Unfortunately, some people end up believing there’s an entirely different bracket for retired people.

Secondly, tax-deferred accounts are subject to Required Minimum Distributions (RMDs) once you reach age 72. This means that you must withdraw a certain amount each year, regardless of whether you need the money or not. These withdrawals can push you into a higher tax bracket and lead to increased taxes owed. So much for owing less in retirement, right?

Tax Deferral at Work

Another part of the issue is that people believe they’re accomplishing a tax “savings.” They feel the impact on their tax bill now, so they don’t stop to think about later. The sobering reality is that if all variables stay the same, there’s actually no real “savings” between deferring money or not.

Imagine you have $100k to invest, and you can either put it in a tax-deferred investment, or an after-tax one. In either scenario, your account will triple between now and when you wish to retire. And finally, whether you pay taxes now, or later, you expect to be in a 30% bracket. Here’s what that would look like:

Taxable vs tax deferred account

That’s right. There’s no difference.

So what’s the better option? Well if you’re just going to invest those funds, why wouldn’t you pay the taxes now when you know what they are? Because out in the future, it’s possible you’ll be living on a fixed income. It’s also possible that tax rates will increase (more likely than them decreasing). And the more income you want, the more you’ll have to lose to taxes if you choose to put your money into tax-deferred assets. Every time you want to withdraw money, you’ll have to remove just a little bit more to pay the government.

Escaping the Tax Deferral Trap

So, what can you do to escape the tax deferral trap? Here are a few strategies to consider:

Early Retirement Exceptions

If you participated in a defined contribution plan and leave work in your 50s, you may be able to get an early retirement exception. This allows you to access your qualified funds before the distribution age without any penalties. Though you’ll still have to pay taxes. While this was meant as a way to provide income to those retiring early under special circumstances, you can use this to pull money out and invest it in other assets that are more tax-advantaged for you. And yes, it’s still okay to be acquiring assets in your 50s, there’s a lot of good 20-30 years can do for you!

Substantially Equal Periodic Payments

IRS Rule 72t, also known as “a Series of Substantially Equal Periodic Payments,” or SEPP, allows you to take equal distributions from your IRA until you are 59-1/2 (or a minimum of 5 years) without penalty.

There are different ways of calculating what your withdrawal amount should be, as explained in this Forbes article. For more details, see the IRS’s FAQ about SEPPs.

This provision is a great way to free your money from a tax-deferred account so that you can free up your after-tax dollars for purposes other than expenses or contributions. This gives you a rare chance to reposition your wealth without penalties for accessing your money early. If you’re ready to get off the stock market roller coaster, you could look at whole life insurance or non-correlated assets.

Get Balanced

If you want to escape the tax-deferral trap, there’s no better time than the present. We recommend reducing your qualified plan contribution only to your employer match. That way you get that “free money,” but you’re not trapping dollars unnecessarily. Then, use that excess to invest in non-correlated assets that can provide income or cash flow, and consider storing your wealth in an asset like whole life insurance.

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