To Tax Defer or Not to Defer?

Have you thought about protecting your retirement from future tax rates that will more than likely be higher than it is now? Would you rather pay taxes at the current rate rather than a higher rate in retirement?

If so, there are such savings vehicles that have you use after-tax money to invest your money and have it grow without tax liabilities in the future.

The interest gained from these types of accounts is not liable to taxation, as long as things are done correctly. The interest can have compound growth without being taxed or required to make required minimum distributions. Once you are retired, you will be able to make withdrawals without having to pay taxes, and if done correctly, this can be handed down to heirs without being taxed as well.

However, the taxes on the money you invest in these accounts will have to be paid now, which many people do not like to do, as they want access to as much money possible now. So they tend to defer their taxes for later.

Common advice many have heard is that you

Should defer taxes until you are making withdrawals in retirement so that you can pay them at a lower tax bracket than when you are working.

This would be ideal if taxes always stayed at the same rate. But that isn’t the case.

To start, let’s take a look at why tax deferral recommendations were made for such a long time when taking a look back at history, and then why this does not apply to these current times.

In the 1960s, those that were paying the top tax rate were paying up to almost 92 percent in taxes. In the 80s, this tax bracket finally had rates under 70 percent during Reagan’s administration. The lowest it dropped to for a quick moment was 28 percent, but the national debt was twice as it had been when President Reagan took office ($998 billion). Meanwhile, the 401(k) was introduced to the public during this time, which also introduced tax deferment as a general practice.

During this period, while the debt was manageable and the taxes were still quite high, it was a good idea to defer taxes.

In this day and age, the country’s debt is around $23.2 trillion and increasing by the second. That is over a 2,300 percent increase since the 80s. We also have $100 trillion forecasted in costs for our social programs such as Social Security, Medicare, and Medicaid.

As interest rates normalize, the national debt’s interest rate will be higher in the future. This isn’t good news as we are already having issues with funding the government throughout the entire year.

Despite our debt rising and it looking quite grim as to paying it off, the current rate for the top tax bracket is 9 percent above what it was during the Reagan administration.

You now have a bit of background as to why the common advice of tax deferment now and pay lower rates later came to be, to escape the hefty rates of the 70s. And with pensions disappearing and 401(k)’s taking their place, the tax deferment advice was tapping on the truth that most would go into retirement with less income coming in and would have to prepare and plan as needed.

What if you plan for a retirement that includes continuing your current lifestyle?

The tax alleviation that many federal workers are expecting in retirement based on this old school advice of tax deferral doesn’t come to fruition with FERS’ (Federal Employees Retirement System) 3 main legs of TSP, their retirement benefit, and Social Security. Particularly where there is no tax diversity in mind while putting money aside for retirement.

Those that implement the tax deferral advice tend to be shocked and disappointed during retirement when they see what it is like with having a pension that is about 99 percent liable to taxes, along having Social Security that can be up to 85 taxable, and Thrift Savings Plan withdrawals that are 100 percent liable to taxes.

Imagine how much more they will be affected if taxes are raised to counter the national debt? So how can federal workers prevent this from happening? By putting their funds into tax-free investments that will provide distributions in retirement that are not considered income.

These investments will lessen the amount of taxes you would be subjected to, which can decrease the amount of your Social Security benefit that the Internal Revenue Service considers taxable. The more money you have that is not seen as taxable income, the more likely the chance to be in a lower tax bracket.

So by diversifying your savings and taxes, you can bring down your income that is considered taxable and then have the taxable amount taxed with a lesser rate.

The most common of these types of accounts that allow you the opportunity to grow your money and not be liable to taxes are Roth accounts. Both Roth IRA and Roth TSP have a lot of options for investing, but they do have a limit on how much you can earn and how much you can contribute.

There is also cash value life insurance, which is a policy that has an investment element which can increase tax-deferred but can be withdrawn without being taxed by the policyholder. The beneficiaries can receive payment as a tax-free death benefit.

You can also invest in municipal bonds, but you must still document any gains, even when tax-exempt to the IRS. These gains may be liable to local or state-level taxes.

With these types of investments, you can diversify your taxes so that you will not receive a significant hit during retirement due to taxation. It is highly advised that you work with a financial professional that has knowledge of your benefits and can show you how you can diversify your taxes for retirement.