Should you halt pre-tax retirement contributions? - ep #82

Mar 14

Welcome to episode 82 of the One for the Money podcast. This episode airs in March which means we are in the midst of tax season and there are numerous ways to reduce taxes. One of those ways is to make pre-tax contributions to your 401k or IRA. You don’t pay taxes now but will pay taxes later in retirement when you withdraw these funds. But in this episode, I’ll share a perspective that argues that certain high earners should halt pre-tax 401k and IRA contributions.

In the tips, tricks, and strategies portion, I will share tax savings tips utilizing a trust.

In this episode...

401(k) Contribution & Tax Efficiency [1:20]
Higher Earners & Pre-Tax Contributions [2:47]
Beneficiary Impact [6:59]
Tax Mitigation Strategies [9:09]

MAIN
In the episode before this one, I shared that saving in a 401k is a great way to ensure you have sufficient income in retirement and a 401k can allow you to do it in an incredibly tax-efficient manner. With a traditional 401k or IRA, you can contribute funds on a pre-tax basis, this is also known as a traditional 401k or IRA. This will lower your taxable income for the year of the contributions. You will pay taxes later when you take distributions from the account in retirement.
And recently Congress passed legislation to help certain individuals save even more. Those are individuals that are between the ages of 60-63 who can now contribute an additional $3750 to their 401k accounts. For those under 50 they can put away in a 401k up to $23,500, and those between 50-59 and 64 and older put away up to $31,000 but retirees between ages 60-63 will be able to contribute up to $34,750 in 2025. Why those specific ages, 60-63, and not 65 or 67, well you’d have to ask Congress.
While this may seem like something one should take advantage of, Ed Slott, a well-recognized tax and retirement expert has argued that certain higher earners should stop funding pre-tax 401ks and IRAS altogether.
Now Ed Slott is a certified public accountant and is a nationally recognized IRA and retirement planning distribution expert, best-selling author, professional speaker, and television personality. So he’s no crackpot. He has even hosted several public television programs, including his latest, Retire Safe & Secure! with Ed Slott which was featured on PBS.
But the key is understanding the specific people that Ed Slott argues should stop contributing to their pre-tax IRAs and 401ks. Specifically, it is for people who have very large pre-tax 401k and/or IRA balances that should stop because the income forced out of these plans in retirement, via required minimum distributions, will result in them possibly being in even higher tax brackets than they are now.
This highlights an issue that I see countless times in my own financial planning practice which is that far too often tax saving strategies can be very short-sighted. The focus often is on how to get a larger refund in the current year and not considering the ticking tax time bombs that we may be setting ourselves up for in the future. The absolute best tax mitigation strategies consider both short-term and long-term implications when it comes to lowering your lifetime tax bill.
The reason why high earners with large 401ks and IRAs should consider stopping funding is that when they reach the required minimum distribution age, they may have to take some significantly high distributions. People would be amazed by how many of the retirees I work with don’t want these distributions. And my financial practice isn’t alone. There are a number of advisors who work with individuals who don’t want the funds from their IRAs.
I’ll share a hypothetical example to give you an idea. Let’s say you have a large pre-tax retirement account at age 60 with a balance of ~$2 million and it grows at a relatively modest 7% until age 75 which is the age your required minimum distributions begin. At that point, your balance would be just over $5.5M. At 75 your required minimum distributions which are based on life expectancy tables show that such a person would have to take out $223,000 in the year they turn 75 and each year they will have to take out a higher percentage. At age 80, even with taking distribution each year prior, a person would be forced to take out $316,000, and at 85, they will be required to take out $418,000. I don’t know many 85-year-olds who need $418k to spend.
If you think these higher income taxes are bad, it gets worse because these higher incomes will also result in you having to pay much higher Part B premiums for Medicare as they are based upon the AGI from your tax return from two years prior. In 2025 a $400k income would result in a monthly premium of $591/month vs the lowest premium of $185/month. That’s a steep difference.
This is why high-earners with large pre-tax 401ks and IRAs should consider not funding these or funding Roth 401ks instead. I mention 401k only because there are no income limits on contributions to a Roth 401k like there are with Roth IRAs.
If you think that is challenging, wait until you hear about the impact on the children who inherit retirement accounts. I’ve had clients share with me that they won’t need the pre-tax IRAs or 401ks that they are funding and they plan to leave these to their kids. While that may sound like a great plan, especially for the kids, it’s a strategy that could lead to you and your beneficiaries paying a lot more in taxes.
Maybe you are asking, just how would you and your beneficiaries pay more in taxes. As I mentioned, you’ll have to take RMDs from 75 until you pass away. But your beneficiaries will have to take out all of the money in a much more accelerated time frame. The SECURE Act that was passed a few years back dramatically changed the distribution rules for beneficiaries. Prior to the Secure Act, non-spousal beneficiaries, children, for example, could distribute their inherited IRAs over their entire lifetimes. I have several clients doing just that right now. But for any non-spouse, ie child, that inherits an IRA after Jan 1, 2020, they will now have just 10 years to withdraw 100%of the funds. The shorter the window, the larger the required withdrawals—and the higher the resulting tax bracket. I have several other clients that are now subject to this new rule. So imagine those who plan to leave their large IRAs to their children. That means the children will have just 10 years to take out the funds, and most likely these distributions will occur when the beneficiaries are in their late 40s 50s, or even early 60s which is often some of the highest earning years. That means, that while you are earning the most money in your career, you are required to take large amounts out of your beneficiary IRAs as well. You’ve got to hand it to Congress, it is an incredibly stealthy way to raise tax revenue by making the inheritors pay the taxes. Because who feels sorry for beneficiaries inheriting money and having to pay more taxes? But with proper planning, more of that money can be spent by the actual beneficiaries and not by the government.
So what’s a person to do to plan better to avoid such a situation? Well, there are a host of strategies one can consider.
The first is to max fund the Roth 401k. You will pay taxes now but you will do so at historically low tax rates. It is likely these tax rates will move higher because we also have a historically high Federal deficit. Both can’t continue. Now with an inherited Roth IRA, your children will still have to take the money out within 10 years, but none of it would be taxable.
The second best option is similar to the first. But instead of contributing to a Roth 401k, you can complete Roth conversions of your traditional retirement accounts.
Roth conversions work just as they sound, you convert portions of your not-yet-taxed retirement accounts to never again taxed Roth accounts. There are no income limitations but since you will be paying income taxes in the year of the conversion it makes the most sense to complete Roth conversions in the years when your income is lower. For example, if you work part-time in the years prior to retirement that is a great time. Another fantastic time to consider Roth conversions is during the years just after you retire and before you have to take RMDs. You will want to have savings in the bank to live on, to make this possible but during those years you could have really low income which would be ideal to begin some Roth Conversions.
I do these for many of my clients. Using my tax return analysis software coupled with my financial planning software I determine what their income is now and what it will likely be in the years to come. This will include income from social security, pensions, rental properties, etc. From that, I determine what their tax rates will be both now and in the future and we convert amounts up to a pre-determined tax bracket.
There are a lot of factors to consider so I would refer you to episode 49 for more details.
The third best option is to put the money instead in a high-yield savings account so you can build up an account that you can live on during the first few years of retirement that will allow you to have low income and complete even more Roth conversions.
The fourth best option is to fund a non-retirement account. This is a great way to build a taxable account that has some advantages over a retirement account. For one they don’t have RMDs, and two there is a step-up in basis when the owner passes so all the account passes to the beneficiaries tax-free.
A fifth option is Life insurance: Taxpayers age 59½ or older could use the net proceeds from pretax retirement account withdrawals to purchase insurance on their own lives, payable to descendants. The tax benefits of life insurance can be exceptional. But you really want to consider a lot of different factors before considering life insurance, such as your health, life expectancy, and the type of permanent insurance. One example of that type would be a GUL type that has little to no cash value and is solely for legacy planning. That type would make the most sense. Sadly that’s not the type of insurance most agents will recommend because their commissions are lower.
A sixth option is to make Charitable donations directly with your RMDs. : Those taxpayers who have already reached age 70½ or are older should plan on making their charitable contributions directly from their IRAs via qualified charitable distributions (QCDs). These donations count as RMDs but not as taxable income, so they allow IRA owners to reduce their tax-deferred balances without paying taxes. That way, appreciated assets in taxable accounts can remain there, without being donated, and eventually pass to heirs with a tax-favored step-up in basis.
Young or old, people with philanthropic intent should cancel all bequests of non-retirement assets to charity; instead, favored causes can be named as IRA beneficiaries. The money can be removed from the decedent’s IRA with no tax for the beneficiary.
As I wrap up this portion of the podcast I must say that for certain individuals it may make sense to pause or stop their pre-tax 401k or IRA contributions and for others it may not. Which camp you may fit into will depend upon a full analysis of your financial picture in its entirety. At my firm, Better Planning Better Life, Inc., we take a root-to-branch approach for our clients. We analyze their tax return with the latest tax analysis software. Next, we project investment balances, and their future RMDs, and run scenarios that can greatly lower their lifetime tax liability. I have to note that all of this is aligned and realigned with the ideal life they shared with us. It’s always exciting to help our clients live a better life because of the better planning we implement, which includes ways to pay fewer taxes.
Thank you again for listening and I hope you found this helpful, now on to the tips tricks, and strategies portion of the podcast.
TIPS, TRICKS AND STRATEGIES
Welcome to the tips, tricks, and strategies portion of the podcast where I will share tax-saving tips utilizing a trust.
One tactic to consider lowering the taxable implications from your pre-tax IRAs and 401ks is to name a charitable remainder trust (CRT) as an IRA beneficiary. Money flowing to charitable beneficiaries won’t be subject to income tax. What’s more, the value of the trust’s assets expected to pass to charity is excluded from the estate tax, which might be a major attraction since the estate tax exemption is scheduled to decline in the future with the sunset of a 2017 tax law.
While we’re on the subject of trusts, remember also that it may not be a good idea to name a trust as beneficiary of a traditional IRA if you are giving the proceeds to your children or grandchildren. It’s far better to name the children and grandchildren as direct beneficiaries and not the trust. Otherwise, it would be taxed at the trust tax rate which is 37% which is met at only $15,000 of income. The required minimum distributions alone on larger IRAs may easily exceed $15,200 and can be taxed at that rate if income is retained in the trust, which may be the case for a discretionary trust that is the IRA beneficiary.
While a trust can allow for more control over how and when the funds are distributed to certain individuals, you will pay a lot in taxes if such a trust is funded with a pre-tax IRA or 401k.
A solution would be to have such a trust be funded with an inherited Roth IRA as there will be tax-free income.
Taking the right steps can result in larger legacies with less taxes owed.
Well, I hope you found these helpful, and until next time, remember a better life is a result of better planning, and that must include tax planning. Have a great one!