I hate to be the bearer of bad news, but you might have less in your retirement account than you think you have! At least the worth to you might be less than you imagine. Really! Your 401k or IRA account balance is not telling the whole story of your wealth — especially if your income levels are high.Huh? Why you ask…Taxes! Taxes I say.
Remember, You Pay Taxes on Your Withdrawals
Depending on your income levels, you might be paying taxes on your retirement account withdrawals. The taxes reduce the real value of your accounts. It is important to remember this fact when making retirement plans.
How Much of the Money Will You Really Have Access to?
The answer to this question depends entirely upon your taxable income for any given year.
As a rule of thumb, if your household is earning
- Less than around $65,000 and you have a relatively low balance in your account, then you won’t pay anything in taxes and the value of your account is actually what you can withdraw.
- Anything more than $65,000 then the tax rate could go as high as 32% on withdrawals meaning that for the highest earners, for every $100 you have, you will only be able to access $68.
The following table with calculations using data from the U.S. Board of Governors of the Federal Reserve, attempts to illustrate how taxes can really eat away at usable retirement funds. (This table, published in Marketwatch, was created with data from 2016, the most recent year for which all information was available. Tax rates have gone down since then, but the chart still illustrates the real effect taxes might have on your actual wealth.):
- For PreTax accounts (401ks, IRAs, Other PreTax), contributions reduce your taxable income and returns are not taxed.
- All distributions are taxed as income. These accounts are also subject to required minimum distributions.
- Starting at age 70.5, the calculator estimates required minimum distributions based on IRS Publication 590-B.
So, Are Retirement Accounts Actually a Good Idea?
The short answer is yes.
The math is complicated, but you are coming out ahead.
Remember, you did not pay taxes on the contributions you made and on the investment returns you have earned. You have deferred taxes on that money for years.
According to Alicia H. Munnell of the Boston College Center for Retirement Research: “A little algebra reveals that the benefit is equal to exempting investment returns on plan assets from taxation. So we come out ahead, even after we pay taxes on the withdrawals. Therefore, the issue is not whether the tax treatment accorded 401(k)s is a good deal. It is, and higher income people benefit the most.”
How To Minimize Taxes on Your Retirement Accounts
Distributions from a regular, or traditional, 401(k) or IRA, are fairly simple in their tax treatment. In most cases, distributions are taxed as ordinary income.
Ordinary income is taxed on an incremental basis. So, the more you earn, the more you pay in taxes.
So, the most obvious way to minimize taxes on withdrawals is to figure out how to minimize your income and keep below certain thresholds.
Taxes: One of the Many Reasons You Can’t Plan Retirement on the Back of an Envelope
A lot of people kind of think about their savings, their expenses and their retirement income and kind of roughly figure out if they’ll be okay in retirement or not.
That is a wholly unreliable method of retirement planning. Inflation, investment returns, taxes and the intersection of those factors plus changes in expenses and income and a lot of other factors require some complicated calculations. If you don’t want to find your retirement projections off by hundreds of thousands of dollars, then it is important that you access the ability to get really detailed about your plans and have a way to do the math. Your options include:
- Building your own spreadsheet, if you have the expertise.
- Using a financial advisor, if you want to have professional advice and are willing to spend $2000 or more a year
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