Federal income tax rates change on a regular basis. In the future, rates may be higher. If a deferred plan participant believes that rates will be higher at the time of retirement and fund withdrawal, he or she should consider whether or not continuing in a deferred compensation plan is a good idea.
The top federal tax rate in 1975 was 70%. In 2010, it was 35%. If someone defers compensation at a 70% tax rate and ends up paying a 35% tax rate, deferral was a brilliant idea. If the reverse is true, deferral was a very bad idea. In either case, the income taxes must be paid when the funds are withdrawn.
Right now your rate may be lower than it will be in the future. Should you continue to defer pre-tax income, hoping that the rate in the future will be lower? The risk is yours.
Should you continue to rely on the idea that “your income will be lower in retirement”? For many people, income in retirement is often the same or higher-not lower-than during working years.
In reality, the more you accumulate in a tax-deferred plan, the more likely is the possibility that your tax rate at withdrawal will be higher. Tax-deferred plans have minimum IRS withdrawal requirements. Since the IRS requires that taxes on deferred earnings be paid within the participant’s lifetime, the amounts required for withdrawal may cause faster withdrawal and thus a higher tax rate. Also, when you add plan withdrawals to other sources of income, the combined income may push you into a higher tax bracket.
You can diversify your tax rate risk by setting up an after-tax retirement account–especially if you already have funds in a tax-deferred plan.
What are some of the benefits of an after-tax account? Consider this:
1. An after-tax retirement account will not reduce your retirement benefits.
In a tax-deferred account, money you choose to tax-defer may not be included in the calculation your employer uses to determine your retirement benefits because deferrals are not considered earned income. Tax-deferred income may cause a lower retirement benefit.
2. In an after-tax retirement account, you have flexibility in making contributions: at your discretion or through an automatic investment plan.
In a tax-deferred account, deposits must occur through payroll deduction. Changes in contribution amounts or frequency are limited by plan rules.
3. In an after-tax retirement account your funds are available to you at any time.
In a tax-deferred plan certain conditions must be met for withdrawal to occur: retirement, termination, financial hardship or death.
4. In an after-tax retirement account your increased account value may benefit from the lower capital gains tax rate when profits are taken.
When you withdraw money from a tax-deferred plan, all withdrawals are taxed as ordinary income-a rate higher than the capital gains rate.
5. In an after-tax account your beneficiary may enjoy a “stepped up” cost basis for capital gains-allowing the beneficiary to assume ownership of the account without tax on its present value at the time of death.
In a tax-deferred plan, your beneficiary must pay ordinary income tax on all inherited funds.
Taxation and changes in your income tax status are important considerations in weighing your investment choices. It’s a good idea not to fall asleep at the wheel. Check with your accountant or tax adviser to plan for future tax consequences.