Just Listen: The IRS Is Telling You How to Have a Tax-Free Retirement
Careful planning and investing are key.
Opinions expressed by Entrepreneur contributors are their own.
Americans had $5 trillion in assets in 401(k) plans in March, and recently Congress has been looking at taxing deposits into these plans up front.
The idea of requiring Americans to pay taxes in advance on their retirement funds, rather than upon withdrawal, has been called "Rothification." That term is based on the Roth IRA, a kind of retirement account funded with after-tax dollars.
Regardless of whether lawmakers look at taxing other kinds of retirement accounts now, or sometime in the future, there are plenty of reasons for Americans to rethink the idea that deferring taxes on their retirement income is a good plan.
Related: This Innocuous Sounding Phrase Is Actually a Mortal Threat to Your Retirement Planning
Many people like using a 401(k) or IRA to defer their taxes. But they forget that the taxman will still come calling on that distant day in the future when they start taking withdrawals from these accounts.
It's a classic example of pay me now, or pay me later.
Here's how this unhappy scenario plays out. The money you put into a conventional tax-deferred retirement plan is money you haven't paid taxes on. Over time, you hope that money grows. Later, you'll pay tax on everything you withdraw from the plan -- as in, every single penny you take out.
In our immediate-gratification society, deferring taxes sounds good when you're putting money into your plan. But keep in mind, when the tax man eventually comes calling, he won't ask you what your tax liability would have been if you'd been paying taxes all along. He'll tell you what your tax liability is at the time the taxes are due.
Think of it as a ticking tax time bomb.
If this sounds overly dramatic, consider our government's unsustainable debt and spending. Politicians have kicked the can down the road again and again, but sooner or later the day of reckoning will arrive. Whenever that happens, higher taxes are inevitable -- regardless of whether or not the current plan for tax reform becomes reality.
One reason has to do with the changing demographics of our country. Baby boomers are getting older and retiring in record numbers. They have less income to tax, and they're beginning to draw Social Security. Who's going to pay for that?
Speaking of Social Security, many people are shocked to learn that when they begin drawing Social Security, they'll have to pay income tax on a major portion of it if they have other taxable income. If you and your spouse file a joint return with a combined income between $32,000 and $44,000, up to 50 percent of benefits may be taxable. And if your combined retirement income is more than $44,000 annually, up to 85 percent of your Social Security income will be taxed as income.
I've surveyed thousands of people asking them what they think will happen with tax rates in the future. Virtually all of them -- including most experts -- believe tax rates will go up. If that happens, and you are successful in growing your nest egg, you'll end up paying higher taxes on a bigger number.
Related: What's Your Safe Money Plan for Retirement?
This is not just speculation. Countless individuals have already discovered -- too late -- that they didn't avoid taxes with their tax-deferred 401(k)s and IRAs. They just delayed paying until retirement, often when they could least afford to be hit with a big tax burden.
Typically, as you age, you have fewer deductions or exemptions. For example, maybe you'll no longer have a home mortgage interest deduction or dependent children. Fewer deductions mean you'll end up paying more in taxes.
Those taxes can devour one-third to one-half of your nest egg.
This often comes as a shock to people who thought the money in their 401(k) or IRA was "all theirs" to spend, according to Boston College's Center for Retirement. In fact, CPAs and financial planners are seeing retirees' tax rates double or more due to a combination of Required Minimum Distributions (RMDs) and taxes due on Social Security income.
The conventional wisdom tells you that you'll be in a lower tax bracket in retirement. That may sound good, but if you're in a low tax bracket in retirement, it probably means one thing: You're poor!
There is one other possibility, however, and it involves you getting to keep more of your retirement dollars. This will only happen, though, if you're smart enough to successfully shield your income from deferred taxation.
Many folks willing to bite the tax bullet invest in a Roth IRA. It's one government-controlled retirement plan that is tax-exempt. But the government restricts the amount you can contribute to a Roth, so you probably won't be able to build up enough cash for a comfortable tax-free retirement. However, there are ways you can supplement those savings.
A high-cash-value dividend-paying whole life insurance policy may be the best way to accumulate wealth on a tax-advantaged basis. You put in dollars on which you have already paid income tax. Then, as with a Roth IRA, you can access your principal and growth with no taxes due as long as your policy remains in force, under current tax law. This is accomplished through a combination of dividend withdrawals and loans against your cash value.
Related: 3 Retirement Pitfalls and How to Address Them
This method can help you keep more of your social security income, too. The IRS does not include the income you take from a policy when determining the taxes you will pay on your social security benefits.
The key to a tax-free retirement is planning and arranging your finances, following IRS guidelines every step of the way. That way, when you retire, it's possible that none of the money you receive will go to the taxman -- not even your social security income.