THE BEST METHOD TO REDUCE YOUR TAX BILL ON YOUR 401K/IRA
IS NOT TO CREATE ONE!
By all appearances, they had done everything correct. A successful career, raising a family of happy children, friends and family nearby, and they had just reached a $1 million threshold in their 401K retirement account. They had many reasons to be proud as we finished listing off their assets on a personal balance sheet.
That was about to change as we started on the liability side of the balance sheet. When I asked about mortgages, credit cards and other debts they proudly and resolutely said, “We have no debt.” Then it happened…I asked if they had calculated the future tax liability on their retirement account. The confident look on their face changed to a quizzical expression.
I have felt it personally and seen it countless times. The reaction we have when uncovering an unknown variable. The discovery of a risk that we was previously unknown. They asked for more information so I once again found myself explaining general 401k/IRA fundamentals.
A 401k gets its name from the section 401, subsection K on the IRS Tax code. This is where the IRS spells out the explicit rules. Simply stated, participants can defer part of their income and the corresponding tax when they make deposits into a plan. Furthermore, the money compounds without having to pay taxes each year. The money grows until the account holder decides they want income or at age 72 when the IRS says it is time to distribute the money from the account based on their formula. Both cause you to report it as taxable income and pay the corresponding tax.
From 30,000 feet, every dollar in the plan establishes a tax liability up to 37% federal plus whatever state income tax will be owed. Of course, no one will incur this liability in any one year. But that is a good news/bad news type situation. The good news is that we think the tax liability really isn’t $370,000 – and that is probably accurate. The bad news is it will be higher. Let me explain…as the account value grows overtime, the tax liability will grow proportionately. The tax liability today is irrelevant. What is relevant is the tax you will pay when you make withdrawals during your lifetime. And then adding to that what taxes will be paid by whoever inherits your plan.
Once you know your total tax liability, it is easy to determine whether a taxable retirement account or a tax-free retirement account would provide more after tax dollars. This 410k/IRA tax analysis is strongly suggested if your household income is over $125,000 and if you have a 401k/IRA account balance that is two times your annual household income. The potential lifetime income tax savings is significant.
The cost for a tax analysis with Coastal Tax Centers is $195. We can assist you with ensuring the financial stability of your future and the future of your family. Contact us at 912.598.2072.