When Too Much Tax Deferral Becomes Counterproductive

Brian Burton

Most of us have been told from early on in our careers to defer as much income as possible to ensure we’ll be properly prepared for retirement.  While not bad advice, most of these strategies involve only qualified deferrals, meaning all income tax gets punted until the distribution phase.  Now, if you do in fact end up in a lower tax bracket during distribution vs. your tax bracket during accumulation, the qualified only deferral strategy may work out just fine; however, this is often times not how it plays out.

 

Consider a retiree that made only qualified deferrals for her entire career, and through accumulation and growth, has amassed quite a large tax-deferred account.  She is now retired and 70.5 years old and must take Required Minimum Distributions (RMD’s) from her account.  Due to the size of the distributions, this individual is pushed into a higher tax bracket in retirement than she ever faced during her working years.  This is a situation where too much tax deferral has created a bit of an income tax problem.

 

Determining the right amount of income to defer vs. how much to accelerate requires a delicate balance.  We don’t want to defer so much that it creates the situation above, but we also don’t want to accelerate too much income that it unnecessarily throws us into higher tax brackets today.  And although we can’t forecast with certainty what tax rates will be down the road, using forecasts for future wealth and some straightforward assumptions about future income and spending, we are able to make approximations for what a person’s tax rates may look like in retirement.

 

Once we have resolved with reasonable confidence what a person’s future tax picture will look like, we then determine whether it is most beneficial to pull more income forward and pay taxes today or to defer more income and pay taxes later.  The goal here is to BALANCE the tax rates we are paying today with our forecasted future tax rates in order to avoid higher tax costs today and in the future.  If today’s tax brackets don’t align with the projected brackets, it may be time to shift some income around from the high-income years into the low-income years.

 

Here are a few strategies that we may recommend to clients when income needs to be shifted:

 

  • Roth Conversions – the process of shifting money from a traditional IRA into a Roth IRA if we think tax rates will be higher in retirement and we want to lower future taxable income (and have the cash to pay taxes on conversion).
  • Take “Unrequired Distributions” from an IRA – if we want to avoid a tax-deferred account becoming too large thus pushing a retiree into a higher tax bracket at RMD age, we may advise taking distributions before they are required.
  • Shift Retirement Contributions – if we want to accelerate income to avoid higher tax rates in the future, we may consider changing retirement contributions from traditional to Roth. Or vice versa, if we want to defer more income taxes, we could shift from Roth back to traditional.

 

I’ve talked to several folks lately that have reached RMD age within the last few years and I’ve been amazed at how many were completely caught off guard by the amount of taxes they’re paying in retirement.  The importance of proper planning cannot be stressed enough here, we want you to be fully prepared so that you can enjoy retirement and not be a “deer in headlights”.  Every family’s tax planning will look different based on their unique circumstances, but the goal here is to get you thinking about how to maximize every dollar you work so hard to earn.

Atheneum