$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 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 types of tax shelters are “good” and should be utilized and that 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.
All signs point to tax rates increasing at some point 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 higher future tax rates. It all equals a very ugly tax picture for retirees.
So 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 them will live to age 90.
–They are conservative investors, so we’ll use a 6% rate of return.
–We’ll use a 25% tax rate.
Let’s take a look at this spreadsheet together (Figure 1) to see if this plan, which many people follow, makes any sense at all.
(Q) How much money does Joe withdraw in the early years, while tax rates are still at historic lows? $0 now and only $25,000-$30,000 in the first few years of distributions.
(Q) How much money does Joe withdraw in the later years, after tax rates have increased? $75,000-$90,000. (Don’t forget the $1 million+ taxable balance to the heirs.)
(Q) Does it make any sense at all to withdraw small amounts when tax rates are low and large amounts when tax rates are high? Obviously not.
(Q) What should Joe do? Start taking out money right now while tax rates are lower!