Beware of This Retirement Tax Trap

INDONESIAKININEWS.COM -  Would you like to pay less in taxes this year? is a trick question. A pertinent answer is another question: will it...

INDONESIAKININEWS.COM - Would you like to pay less in taxes this year? is a trick question.

A pertinent answer is another question: will it cause me to pay more in taxes later? If not, duly paying less in taxes is a no-brainer. 

But when paying less in taxes now is merely tax-deferral, the decision can be brain-racking.

It involves comparing the tax reduction received now and the taxes expected to be paid later. 

We’d rather not pay more later than we save now. So, before kicking the tax can down the road, it’s wise to look ahead.

This matters a great deal because opportunities to defer taxes abound. For instance, retirement saving commonly involves tax-deferred accounts like 401(k)s, IRAs, and 403(b)s. 

Although they’re individual accounts, we might as well think of them as joint accounts because Uncle Sam expects his share when we take withdrawals. 

How much we get to keep depends on how good a long-term tax plan we craft.

Tax aversion may compel retirement savers to defer all the taxes they can, year after year. Sometimes, that’s the right thing to do. But not always. 

Common Examples

The common assumption justifying retirement tax deferral is that we’ll be in lower tax brackets in retirement than during our working years. 

It’s a general assumption that’s not always true. While we’re saving for retirement, we might be in a low tax bracket due to the mortgage interest deduction, the benefit of having dependents, and filing married-jointly, for example.

By contrast, we might be in higher tax brackets in retirement because of wealth accumulation or using the single filing status.

When retirees have too little money outside tax-deferred accounts, exceptionally large expenses can require taxable withdrawals that cross into painfully high tax brackets. 

Then, taxes might dissuade retirees from taking discretionary withdrawals they would otherwise enjoy (e.g. remodeling, bucket-list travel). 

For unavoidable expenses, such withdrawals can add tax salt to the financial wound.

To make matters worse, the cost of receiving Medicare parts B and D can increase when income goes up, thus potentially amplifying the cost of taking money out of tax-deferred accounts.

Postponing distributions from tax-deferred retirement accounts can also build a tax trap. 

Generally, distributions may be taken penalty-free starting at age 59 ½ and must be taken yearly starting at age 72. These are the notorious Required Minimum Distributions or RMDs. 

One of the tax code’s many exceptions allows employees to postpone RMDs past age 72 if they keep working, among other requirements. 

Therefore, I once met an employee in his eighties who had deferred distributions so long that he couldn’t bring himself to retire and pay very high taxes on his 401(k) account’s RMDs. To tax defer can retirement deter!

It's a rare situation and the moral of the story is not to avoid tax deferral. Not at all. The lesson is to start early on a long-term tax plan.  

Source: thestreet