Spring time is amusement park time. As a kid, how fun was it to run into the park, grab some cotton candy and chocolate milk before your parents got your day organized? Then it was off to the rides. A drive around the Autopia, a ride through the Small World, and then to the Matterhorn! We all remember having a great time sprinting as fast as we could from ride to ride.
Now that we’re all grown up, spring is tax time. What happened? Instead of parents telling us what we should eat and which rides we could go on, we now listen to accountants tell us our tax bill and give us advice advocating contributions to deferred retirement plan. Some even offer the advice with the words “you will save on taxes”. Well, before you believe such words to be true, I think it’s important that you understand that deferred plans do two things:
- Defer tax payments on contributions and potential income/growth within the plan
- Defer the determination of the income brackets and tax rates applied to withdrawals
Most of us like the idea of deferring tax payments, but what many are discovering is that the government’s decision to increase tax rates is now negatively impacting their after tax spendable retirement income.
I’ve been talking about “tax rate” risk for 6 years since the launch of Westface Financial, and I’m sad to see the day when higher tax rates are upon us. With Prop 30 in California raising state income tax rates retroactive to 1/1/2012, and federal income tax increases taking effect 1/1/2013, this conversation is no longer theoretical.
While I’m deeply concerned about higher tax rates impacting withdrawals from deferred plans, I do believe some clients can still benefit from participating in these plans if it’s part of a well-coordinated overall financial strategy.
The core motivation to use a deferred plan is the belief that there will be a lower tax rate applied to withdrawals compared to the tax rate that would have been applied to contributions.
Many factors will impact the real life result. The obvious are the applicable tax rates at the time of contribution and withdrawal. But we also need to consider the dollar amount of the expected withdrawals.
Our income tax system is built on a set of income brackets and increasing tax rates per bracket. The more you make, the more of your income falls into higher brackets and is subject to higher tax rates.
So, if a family saves most of their money in a deferred plan, and saves enough to fund an inflation adjusted retirement income similar to their working years, they are very exposed to future tax rate changes.
On the other hand, if a family splits their savings between a deferred plan and a tax free plan, they are much less exposed to changes in future tax rates. Such a family will be able to adjust their deferred plan withdrawals year by year to manage how much of their income is subject to higher or lower future tax rates.
In general, the younger you are the more “tax rate” risk you take with a deferred plan as the future tax brackets and rates are a long ways off. Also, the younger you are, the more “liquidity” risk you take as money inside a deferred plan is penalized in most cases if it’s withdrawn before the age of 59 ½. Another factor for younger families to consider is that most make lower incomes starting out, and then make significantly more as they advance in their careers. If they contribute to a deferred plan early, it’s likely the deferral brackets and tax rates are low compared to retirement. This is the exact opposite of what makes the deferred plan tax beneficial.
On the other hand, the closer you are to retirement, the less “tax rate” risk you take as future tax brackets and rates are closer in time, and you have more clarity about your level of retirement income.
Whatever your particular situation, the decision to contribute or not to a deferred plan should encompass analysis far beyond the April tax bill. While it might feel good short term to reduce that tax bill, you could end up creating a lot of long term financial pain in your retirement lifestyle if you’re not careful.
At Westface financial, we base all our advice on a long term financial plan that looks well beyond any one tax bill. And just like your parents warned you about eating and drinking too much before the rides, be careful with any advice you get that doesn’t contemplate what’s next.
As you might have learned the hard way, while cotton candy and chocolate milk taste great, if your next stop is the Matterhorn, it probably won’t taste so great the second time.
Author: Mark Guthrie of Westface Financial and Insurance Services
This is written as a general information article meant to help the reader understand basic concepts in personal finance.
Nothing in this article should be considered a guarantee of any investment performance.
An investor should consider his or her current and anticipated investment horizon and income tax brackets when making any investment decision. This article does not reflect factors for any individual reader.
Tax and/or legal advice is not offered by Mark Guthrie. Please consult with your tax professional or legal professional for additional guidance regarding tax and legal related matters.