One of the biggest myths in the financial world is that IRAs and 401ks are meant to give you tax deductions in your pre-retirement years, allow for tax-deferred growth, and then you can withdraw funds during retirement when your income will be much lower. This means you would avoid paying taxes at the highest federal income tax rates. Just a few weeks ago, I was on a call with some clients and a financial professional who told us that in the 24 years he has been working with his clients, not one of them had fallen into a lower tax bracket during retirement, mainly because of mandatory distributions.
The reality is that large accumulations of money in tax-deferred accounts meant that by the time the government is forcing withdrawals from these tax-deferred accounts through Required Minimum Distributions (RMDs), pensions, social security, and other types of investments are pushing clients into the same or higher tax brackets they were paying before retirement. With the new SECURE Act, the tax issues only become worse when clients have until age 72 rather than age 70½ when they are forced to take distributions. Compounding the problem is that we have some of the lowest federal income tax rates since World War II, and with recent government spending, tax rates are likely to go up. So if you are avoiding taking money from retirement accounts now because you don’t want to currently pay income taxes, the problem is only likely to get worse.
The second issue is that our clients in their prime working years have been dealt a serious blow to their income taxes if they inherit IRAs and other tax-deferred accounts from older generations. It used to be that people inheriting retirement accounts were subject to required minimum distributions on “inherited IRAs” that spread the minimum withdrawals and accompanying taxes out over a few decades. That has now been relegated to a flat ten year period after inheritance with NO required distributions until the last year. Human nature and the urge to pay as little in current taxes as possible means a nightmare scenario is more likely than not to happen. I can imagine someone inheriting a $300,000 IRA from a parent. The SECURE Act says they will not have to take any distributions for the first nine years, so they take nothing or very little out because they are in their “working years” right now. By the time year ten comes around, the account has grown to $500,000, their own income is $175,000, and in the year 2030 the income taxes would be $232,526. And that is if the tax rates haven’t increased.