For many years, the common advice regarding managing finances in qualified accounts like 401(k), 403(b), and IRA has been to defer tax liabilities on these assets for as long as possible to enjoy unhindered growth. The logic is simple: why pay taxes now when you can pay them later? However, as these accounts grow, so does the tax liability, along with the potential future pressure from required minimum distributions (RMDs), which could affect your tax brackets and Medicare premium surcharges.
It’s worth mentioning that postponing taxes may not always be advantageous and could potentially cause significant harm. If tax rates increase in the future, it could lead to considerable losses. Currently, the tax liability is relatively low compared to historical standards. Therefore, it might be wise to settle this liability now rather than later.
One of the risks associated with deferring taxes into the future is the uncertainty surrounding tax rates. Although tax rates are relatively low now, thanks to the Tax Cuts and Jobs Act of 2017, they are set to increase after 2025 unless Congress extends the current rules. Moreover, tax rates could rise further in subsequent years as more people retire.
Additionally, other life events could lead to higher tax rates for retirees. For instance, the death of a spouse or a divorce could change a person’s tax-filing status from joint to single, potentially resulting in higher taxes.
There’s also the possibility that Congress might decide to raise tax rates to address ongoing spending issues.
Another aspect to consider is the deferral of capital gains in non-qualified accounts. In an attempt to minimize their tax payments for a particular year, many individuals refrain from selling stocks that have appreciated significantly. This behavior, driven by tax aversion, could lead to an over-concentration in a single stock.
Regarding investment returns, the focus should be on managing risk and thinking in terms of net gains after taxes and limiting your taxes in retirement. This involves settling a liability at a reasonable tax rate like now, rather than at a potentially higher rate.
It’s also important to pay attention to the ‘tax location’ of assets. This means differentiating between how your qualified accounts (like IRAs and 401(k)s) and non-qualified accounts are invested. For example, withdrawals from a traditional IRA are taxed as ordinary income, regardless of the assets held within the account. However, the taxation of non-qualified accounts depends on the type of investment asset owned.
Lastly, there’s a long-term advantage to having assets in a Roth IRA. Although you don’t get to defer taxes on the money you deposit in a Roth, the growth and withdrawals are tax-free. This means you don’t have to worry about future tax rates affecting your retirement withdrawals.
In conclusion, while deferring taxes has been the conventional wisdom, adopting a long-term perspective in investing and tax planning is essential. It’s not about who pays the least amount of taxes now but who manages to limit their long-term tax liability and enjoys a more financially secure retirement.