The other tax bomb in retirement

You’re probably familiar with the debate over tax-deferred versus tax-free retirement accounts, with the argument that you should avoid tax-deferred accounts to avoid a tax bomb in retirement. You’ll also find that most “expert” opinions favor tax-free Roth accounts, such as a Roth IRA or Roth 401(k), as the best choice for retirement savings. I agree for the most part (I’ll save that “most part” explanation for another day).

And most of us make this decision without ever calculating the numbers: how much tax is paid today on Roth contributions versus the tax paid on future 401(k) withdrawals? But you can’t do an accurate calculation today because you really don’t know what your tax rate will be at that time, so far in the future. Let alone how much your savings will grow, which affects how much tax you’ll eventually pay with a tax-deferred account. Nevertheless, many choose tax-deferred accounts simply because they like paying less tax today and will worry about the tax problem in retirement later.

This question of paying tax today or later in retirement is more far-reaching than just choosing which type of account. It’s because all your savings and assets will be taxed one way or another unless steps are taken to avoid it. For example, you put your savings in CDs at the bank with dollars that have been taxed at your current income tax rate. From then on, you’ll add the bank interest to your tax form, paying some additional (but likely small) federal and state tax every year. If you take the money out, it’s tax-free, but you won’t do that unless you really need the money, so as it sits in a bank, there’s a tax hit every year based on the interest earned. Either taxes up front, ongoing, or later.

While we think of real estate as an asset to pass on to our children tax-free, that’s only possible if you keep the property title until your last breath. Need to sell it at age 85 to afford assisted living? A large or small tax bomb is waiting. And there can be many of these minefields we forget about, because our money is taxed when we hold onto it, when we change asset or account types, or after we’re gone, when the tax bill is handed to our loved ones.

One exercise all near retirees or retirees need to do is to assess their tax impact over the retirement years and when they pass. One method is to make a list of all your accounts and assets. Then, in three columns, list (a) the tax impact of holding the account or asset (i.e., taxed as income; interest and dividends), (b) the tax impact of selling the account or asset (capital gains), and (c) the tax impact on beneficiaries. Next, if you can’t put numbers to the impacts, at least categorize them by value - as minimal, moderate, or significant - and note when: yearly, when sold, or inherited.

After completing this exercise, you start to see the next challenge: how to minimize the tax bill while still achieving the outcome you want. You might think you’ll use up your Roth savings because it's tax-free, but instead, you could invest your brokerage account for dividends that are tax-free at your income level and save the Roth for your children. Thus, the exercise helps you weigh the trade-offs and plan to move things around for a better outcome, rather than waiting for the tax bombs to go off. Of course, you or your heirs will be stuck paying some taxes, but the goal should be to minimize them and not be surprised by impacts you didn’t know or consider.