$16.6 trillion: According to the Investment Company Institute in Washington, that’s how much money Americans have stashed in qualified retirement plans as of the end of 2006. It’s a lot of money–and it’s never been taxed.
Many, if not most, Americans believe that their qualified retirement plan is a great tax shelter. And why shouldn’t they? They hear from every financial source that they should put as much money as possible in their qualified retirement plans. Everyone seems to agree that these tax shelters are “good” and should be used; the only argument is where to invest the money once it’s inside the plan.
But what happens at retirement? What happens when it’s time to withdraw money from these accounts? That’s when we discover that our qualified retirement plans are our highest taxed asset. No other asset, throughout our entire lives, is taxed at a higher level than our qualified retirement plan in retirement.
We only have to watch the 60 Minutes interview with David Walker, head of the Government Accountability Office (aired March 4, 2007) to learn that we live in a time where Washington’s lack of fiscal responsibility is coming to a head. That suggests tax rates will increase in the near future whether we want them to or not.
So let’s add this up: Trillions of dollars in retirement plans that have never been taxed plus massive fiscal irresponsibility in Washington leading to higher tax rates. It all equals a very ugly tax picture for retirees.
What is a retiree to do? To answer that question, let’s take a look at a typical retiree with $500,000 in his retirement accounts. We’ll make the following assumptions:
? Both husband and wife are 65 years old and in good health.
? The IRA is in the husband’s name (Joe) and the wife (Carol) is the primary beneficiary.
? Using TIAA-CREF’s 2003 mortality tables as a guide, we’ll assume that at least one of the spouses will live to age 90.
? Both husband and wife are conservative investors, so we’ll use a 6% rate of return.
? We’ll also assume a 25% tax rate.
Let’s look at this spreadsheet together (Figure 1) to see if this plan, which many people follow, makes sense.
Question: How much money does Joe withdraw in the early years, while tax rates are still at historic lows? Answer: $0 now and only from $25,000 to $30,000 during the first few years of distributions.
Q: How much money does Joe withdraw in the later years, after tax rates have increased? A: From $75,000 to $90,000. (Don’t forget the $1 million plus taxable balance to the heirs.)
Q: Does it make any sense to withdraw small amounts when tax rates are low and large amounts when tax rates are high? A: Obviously not.