Retirement Planning: More Money in My 401(k)?
In a recent post, we discussed some of the considerations of a non-qualified deferred compensation plan. A non-qualified deferred compensation plan is just one kind of tax-deferred investment account. There are many different types of tax-deferred investment accounts, including:
- Individual Retirement Arrangement (IRA) Accounts
- Self-Employed Employee Pension (SEP) IRA Accounts
- Section 401(k) accounts
- Section 403(b) accounts
- Pension Plans
- And more . . .
Taxes on Your Tax-Deferred Investment Account
With a tax-deferred investment account, investments grow tax-deferred. Investment gains in the account, from the issuance of cash dividends and the realization of capital appreciation are not taxed – at least until distribution. At the time of distributions, money being withdrawn from the account is subject to taxation at the marginal rate. The marginal rate is the same tax rate that your pay stub is subject to.
Though being taxed at the marginal rate is not a good deal (at least compared to the preferred long-term capital gains rate) there are tax savings up front when making contributions to a tax-deferred account. Participants in tax-deferred accounts may receive a tax deduction on their contributions.
Planning Retirement Distributions with Tax-Deferred Accounts
Many financial planners and accountants alike love tax-deferred investment accounts (because of the retirement funding and tax savings it provides, respectively). Both of these parties like to make the case:
If you’re in a higher tax bracket now than the tax bracket you anticipate being in while in retirement, it then makes sense to put money into tax-deferred accounts.
Under normal circumstances, it almost always makes sense to:
- contribute money to a retirement account
- claim a tax deduction for your contribution at a high tax bracket
- withdraw money from that investment account at a lower tax bracket
Even in the absence of any investment growth, this is a great deal – courtesy of Uncle Sam.
Big Plans for Retirement
However, while tax-deferred growth can be a good deal, paying taxes on the way out may be a bad deal in some circumstances. Recently, we came across that very circumstance (i.e. a circumstance why cramming money into an IRA, 401(k), etc. may not be a good idea). Our financial planning client, Imperator Caesar Divi Filius Augustus:
- Has surplus income that he was using to fund his tax-deferred account
- Anticipates a lower future tax bracket in retirement – relative to his existing tax bracket
However, what differentiated this client was his plans for retirement. That is, he had some very big plans – both in terms of cost and scale.
The Case Study of Augustus, the Retired Remodeler
At the onset of retirement, Augustus planned to re-model his home city of Rome. Such a plan was going to be very, very expensive. In fact, the sheer size of the cost of this project necessitated that Augustus take a massive, up-front distribution from his tax-deferred retirement accounts. Because the distribution was so large, Augustus was pushed up into the highest tax bracket. Where before Augusts had received a tax deduction for his retirement account contributions at a rate of 33%, Augustus was now looking at paying 39.6% on his distributions.
In this scenario, Augustus had some severe liquidity constraints in that the entirety of his funds were tied up in tax-deferred accounts. Fortunately, we were able to meet with Augustus several years before his retirement, helping him with his retirement plan. By analyzing Augustus’s expensive renovation plans relative to his existing retirement accounts, we determined that making further contributions to tax-deferred accounts (while still employed) may be a poor move. As an alternative, free cash could either be put into a conventional taxable investment account, or into a Roth IRA (via a back door conversion).
Planning for Your Own Large Distributions from IRA or 401(k) account in Retirement
Now, not every financial planning client has such great plans as Augustus. That is, not everyone needs to remodel their entire home city. However, many times retirement plans may start off with a similar boom – in spending. Said another way, many of our retirement planning clients anticipate large distributions at the onset of retirement, distributions that will invariably move them up into a high tax bracket – a higher tax bracket than they were in when they made the original contribution.
Consider a few real-life examples (from our very own clients) of large expenditures occurring at the onset of retirement:
- Purchasing a luxury sedan
- Paying off the balance of your mortgage
- Buying a second home in Panama
In short, if you’re approaching retirement, and have some big (read: expensive) plans at the onset of the second stage of your life, work with a fee-only Certified Financial Planner® (CFP®) to determine if it still makes sense to continue contributing to your tax-deferred retirement accounts. You just may find that it may not sense given the tax consequences and shorter timeline.
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Working with a fee-only financial planner means your financial advisor has the single objective of mapping out your life for your benefit, without the conflict of interest that comes the desire to sell financial products for a commission. As a fiduciary, a fee-only Certified Financial Planner® (CFP®) works for you!