The Catch-22 of Tax-Deferred Retirement Plans

Are You Making Faulty Assumptions About Your Retirement Savings?

We’ve shared on our blog previously about the dangers of over-utilizing tax-deferred accounts. So many clients come through our doors having followed advice from so-called financial gurus who tell them it’s okay to have all their assets in tax-deferred accounts because they’ll be in a lower tax bracket in retirement. Of course, this is a faulty assumption, and I encourage you to read the above-linked article for more on that.

In this article, I will further explore the pitfalls of the tax-deferred bucket, and I’d like to reference Joseph Heller’s Catch-22. The underlying theme of this famous book can help shed some light on the true nature of tax-deferred accounts.

Catch-22

The main protagonist in Catch-22 is named Yossarian. He and his friends serve in bomber crews during World War II, stationed at an airbase off the coast of Italy. One by one, his friends fly into battle, get shot down, and never come back.

Soon, Yossarian begins to realize that if he continues going on these bombing missions, he too will be shot down, and never come back. So, he begins to study the Air Force rules and regulations. And he comes across rule number 22.

Rule 22 says that if you can successfully plead insanity, you can get honorably discharged from the Air Force. He decides that this is what he should do. So, he goes up to the Air Force physician and asks to be released from duty on the grounds of insanity. However, the physician says that the fact that Yossarian is trying to get out of flying these bombing missions is actually proof that he is perfectly sane. Therefore, he must continue to go on these bombing runs. Thus, the title Catch-22.

Do we still use the phrase “catch-22” today? You bet we do. It’s like being stuck between a rock and a hard place. Darned if you do, darned if you don’t. I refer to this story because any investment in the tax-deferred bucket is a perfect modern-day example of a catch-22.

Is a ‘Tax Train Wreck’ Threatening Your Retirement?

If you keep contributing to tax-deferred accounts on the assumption that you’ll be in a lower income tax bracket in retirement, it’s time to rethink your retirement plan.

The Tax-Deferred Dilemma

Here’s what I mean when I say tax-deferred investments are a catch-22:

The Rock

You have to remember that the IRS wants to tax you on your money so badly that, at a certain point, they will force you to take money out. This happens at age 70 1⁄2, and it’s called a Required Minimum Distribution (RMD). If you forget or choose not to take the money out, the IRS imposes what’s called an excise tax. In reality, it’s a penalty, and it’s an astounding 50% of your RMD. In other words, if you were supposed to take out $10,000 but didn’t, you would get a bill in the mail for $5,000. And that doesn’t even include the income tax! Throw in another 30% (24% federal and 6% state) for that, and you’re looking at forfeiting 80% of whatever you were supposed to take out but didn’t. As you can see, the IRS is pretty serious about getting their money.

The Hard Place

Now we understand what happens if you don’t take enough money out of your tax-deferred investments.

But what happens if you take out too much? Beyond paying increasingly higher amounts of tax, the IRS says that as much as 85% of your Social Security becomes taxable. What?! You may be thinking, “Social Security felt like a tax when it came out of my paycheck, and now they’re going to tax it before I get it back? That’s like a double tax!” Sadly, you read correctly.

The Bottom Line on Tax-Deferred Accounts

If you take out too little, you will pay a big penalty to the IRS. If you take out more than required, you pay higher taxes on your Social Security benefits. Talk about a catch-22!

As I’ve said in previous articles, deciding whether to contribute to tax-deferred accounts really comes down to what you think about the future of tax rates. If you think that your tax rates in the future are going to be lower than they are today, you should put as much money as you possibly can into tax-deferred investments. Get the tax deduction at today’s higher rates and pay taxes at a lower rate down the road.

If, conversely, you believe that tax rates in the future will be higher, even by 1%, then mathematically you are better off limiting your contributions to tax-deferred accounts.

If you’re interested in learning more about how you can lower your tax bracket or reach zero tax liability in retirement, let’s start a conversation. Call to schedule a strategy session and take the first step toward a more financially secure retirement.