Questioning: Tax-Deferral
One of the things that seems universal is that we don’t like paying taxes. We do it and benefit from them in a lot of ways, but we also prefer to pay as little each year as we can and keep money for ourselves.
A key way people try to do this is through tax-deferred accounts like your 401(k) or contributions to your IRA. Often, a tax professional will say something to the effect of, “If you make a contribution to your account you will save X dollars in taxes.”
There are a few connected ideas behind that statement that I’d like to put under the microscope and see if we actually “save” on taxes by doing this.
The first idea behind this method is the idea that when you make the contribution that amount is at the highest part of your marginal tax bracket. Example:You put it in $6000 to your IRA at the 22% tax bracket. You would defer $1320 in taxes.
The second idea is that when you take the money out of your IRA you do it at a lower tax bracket. Example: Distribute $6000 at 12% in retirement. You pay $720 in taxes.
Thus, you saved on taxes because $1320-$720=$600 saved!
There is a common refrain from advisors, CPA’s and tax preparers that you will be in a lower tax bracket in retirement than you are now. Maybe. We really do not know and a lower tax bracket may mean higher taxes paid.
I know that makes no sense on the face of it so let’s do some more math! Yay!
All of these calculations are based on the median income of $80,000/year and filing single.
Say we do this for 30 years with no changes to the situation.
$1320 x 30 years = $39,600 in taxes that we deferred over time. Let’s say our account grew over time to $680,000 with an 8% rate of return over that time. That is pretty exciting! Now what?
We start taking money from this account and living off the money. The question I ask here is how much money, how many distributions and how many years before you owe more taxes than the $39,600 you deferred along the way.
Do we end up paying more dollars even if we are in a lower tax bracket?
If you take out $30,000 a year, you owe about $1616 in taxes. This means you can do that for 24 years before you pay more than you deferred.
If you take out $50,000 a year, you owe about $4016 in taxes. This means you can do that for almost 10 years before you pay more than you deferred.
What if you need a larger portion because of an unexpected expense? Say you had to take $100,000 one year, you owe about $13,841. If you have to do that 3 times, you will end up paying more taxes than you deferred.
There are very specific, very strategic and very precise tax strategies where you can end up paying $0 in tax deferred accounts but the minute you encounter something outside the narrow model, you may end up in a tax pickle.
Make sure to ask your tax pro what the taxes look like on the way out versus the way in.
If you want to play with taxes, and I know you do, check out SmartAsset’s income tax calculator.
https://smartasset.com/taxes/income-taxes#0oB1Cxn6Iy
As always, if you come across a financially related article you’d like to send my way please do!
Best place to send them is to me.
More next time!
Jonathan