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How to make sure you keep your retirement money

Most people, regardless of how much income they earn, are taught that setting aside money in an employer-sponsored and/or individual retirement account is the best way to ensure that money will be available in the future.

But the truth is, that’s only partially right. While saving and investing can certainly help you to build up a nice-sized account, what really matters is how much income you’ll be able to put in YOUR pocket when you need it, and whether or not it will be enough – after taxes – for you to maintain your preferred lifestyle.

Unfortunately, knowing the exact amount of income tax you’ll have to pay in the future can be a bit like herding cats – you just don’t know ahead of time how much you’ll actually be able to reign in.

So, how exactly can you plan for this unknown variable that can make a substantial impact on the amount of income you’ll net during retirement?

One way is to take control now and ensure that you can count on tax-free income sources so that regardless of what the income tax rates are, you’ll be cutting Uncle Sam (legally) out – or at least reducing his portion – of what you’ll reap from your hard-earned savings.

Taxable vs. tax-free income in retirement: What you need to know

If you’ve been socking money away in a traditional IRA, 401(k), or other type of qualified retirement account, you may be happy that some or all of your contributions are tax-deductible, and that the money inside of the account grows tax-deferred.

Yet, while these are certainly nice benefits to have right now, they can come back to haunt you when the time comes to start making withdrawals. Uncle Sam is no dummy when it comes to making tax-related tradeoffs, because he knows that he’ll be benefitting from the taxes that are levied on a much higher amount in the future. 

- We don’t know what income tax rates will be down the road, so it’s difficult to plan for an unknown.

- What we do know, however, is that more than once over the past 100 or so years, the top federal U.S. income tax rates have been in excess of 70%...and in some years, more than 90%!

With that in mind, it is important to secure sources of tax-free growth and income so that the government doesn’t end up with the majority of your retirement income.

How to plan ahead for an unknown tax liability

Thanks to a massive tax reform that was enacted in the waning hours of 2017, the top marginal income tax rate of 37% hit single taxpayers who have taxable income of $500,000 or more, and $600,000 and higher for married couples who file their taxes jointly. 

For 2019 and 2020, the tax rates remained unchanged from the prior year, but that isn’t to say that they won’t go up in the future. In fact, given the significant amount of debt and unfunded liabilities of the U.S. government, it’s a pretty sure bet that taxes will increase…possibly by a significant amount - going forward depending which political party has control. This could have a dramatic impact on the amount of money you’ll have to spend.

Taxes have nowhere to go but up

Not too long ago (in early 2019), the United States’ national debt hit a record high of over $22 trillion – and over the next decade, annual federal deficits (i.e., when Congress spends more than it brings in via tax revenues) is expected to skyrocket.

If you divide that debt figure out so that we all pay our “fair share,” the Federal debt per person in the U.S. comes to roughly $66,000. Unfortunately, this amount does not include state and local government debt. 

Nor does it include the government’s “unfunded liabilities” for entitlement programs like Social Security and Medicare – and the fiscal strain on just these two programs alone could make YOUR individual share of the debt even higher.

Why is this such a concern for you?

There are actually several reasons.

- Let’s start with the initial group of Baby Boomers who started turning age 62 back in the year 2008. At age 62, qualified individuals can begin drawing Social Security retirement income benefits (albeit at a lower dollar amount than waiting until full retirement age). 

- Just a few years later, in 2011, this same group of Baby Boomers started turning 65, the age where Medicare benefits begin. Now, with approximately 10,000 Boomers turning age 65 every day through the year 2029 (when the last of this cohort reaches their 65th birthday), the immense financial strain on these government programs could be enough to bankrupt them…that is, unless something changes. 

Throughout history, the government has “solved” many of its financial issues by taking more from the U.S. taxpayers. When the Social Security program started back in the mid-1930s, there were plenty of workers paying into the system to fund the recipients’ benefits. But over time, with more retirees receiving benefits, coupled with fewer workers paying in, the Social Security program could reach a breaking point.

It is estimated that the ratio of workers to retirees will continue to fall, hitting a new low of 2.4 in the year 2030.

Based on information from the U.S. Congressional Budget Office, if the Social Security, Medicare, and Medicaid programs go unchanged, the rate for the lowest income tax bracket could increase from 10% to 25%, and the highest federal income tax bracket could go to 88%!

I don’t say this to scare you, and although I believe it is unlikely for rates to get back up to the 90% range again, it is essential to plan for multiple scenarios now rather than later, because waiting until later could be too late. 

What to do if taxes go up

While it is certainly possible that income taxes may go up in the future, it’s likely that any increase will be a gradual process over time as versus any significant yearly jumps. So, withdrawals from any tax-deferred accounts will require you to pay your share of income tax on the gain, as well as on any pre-tax contributions that you made. 

Anticipating these taxes is a must, so that you have a better idea of how much of your retirement income you’ll have available to spend, as versus giving up in the form of taxes. In addition, although many financial advisors believe that retirees are in a lower income tax bracket once they stop working, this is not necessarily always the case depending on their investments and assets. 

Overall, though, for tax purposes, it is usually best to make use of tax-deferred retirement accounts during peak earning years. However, having at least some of your funds in post-tax retirement accounts can help you to better diversify your income stream in retirement. Let’s take a closer look at what you may anticipate, and how you can best plan ahead.

Income taxes and retirement plans

One of the primary sources of revenue for the IRS comes from income taxes – and there is a treasure trove of taxable funds to draw from in certain types of retirement plans. If you’ve been growing your nest egg in a plan that allows for tax-deferred growth, you could find that a portion of your savings will eventually end up in Uncle Sam’s pocket. 

Although the terms “tax-deferred” and “tax free” might sound very similar, they are actually two extremely different concepts. For instance, tax free means just exactly that – the money in the account is allowed to grow and be accessed through withdrawals without having to pay taxes on the gain.

To the contrary, an account that allows tax-deferred growth won’t require you to pay taxes each year on the investment gains – at least while the money is still in the account. But you will have to pay tax on the withdrawals, which can often be a much larger amount than what you have contributed.

Get an expert overview of each retirement plan so you can make an informed decision.

There are a number of different types of investment accounts that qualify either as tax-deferred or tax free - and it is important that you know how your money is being treated with regard to the taxes in each of these.

What’s the difference between defined benefit and defined contribution plans? What do you need to know about SEPs, SIMPLE IRAs, 401(k) and solo 401(k)?  How will hiring employees affect your retirement plan, and can you employee a spouse for greater benefit?

These are all important questions to consider, and I could write a blog (or several) on each question, not to mention on each plan! Instead I’ve compiled a comprehensive list of answers and comparisons in my book: Advanced Tax Planning for Medical Professionals. This book provides a foundation for basic and advanced tax planning. You’ll read real-life examples of medical professionals who saved big just by using these strategies. You’ll also receive exclusive tax strategy resources to help you get started right away.