401ks and traditional IRAs have long been the favorite mechanism for saving for retirement. For many years, people have operated under the false belief that it is always best to maximize contributions to your retirement plans. However, there are many issues with these plans and it is quite possible you are doing yourself a great disservice by maximizing the amount you contribute each year.
From both a tax perspective and investment perspective, there are a number of issues with traditional retirement plans such as 401ks and IRAs. It is important while reading this article to keep in mind that we are covering traditional IRAs and 401ks. Many of the disadvantages mentioned below do not apply to Roth-IRAs or Roth-401ks.
The key point to emphasize is that there are other options that can accomplish the same objectives as 401ks and IRAs that are more beneficial from a tax and investment perspective. Get in touch with us today for a tax strategy plan to determine what approach makes the most sense for you.
Tax Disadvantages of 401ks and IRAs
Chances are we have all heard the plug for 401ks and IRAs from financial advisors and CPAs. The general idea is that you avoid paying tax today on amounts contributed to your plan so that it can be invested on a tax-free basis and grow over time. Then, when you retire, you take distributions to fund your living expenses. This is all of course based on the premise that when you retire, you will be in a lower income tax bracket.
There are a number of issues with this line of thinking.
- Tax rates are likely to increase
We cannot predict the future. It is impossible to guess what tax rates will be when you retire. However, with the current amount of debt and the state of social security, it is probably a safe assumption that tax rates will increase over the next few years. I have yet to meet a tax professional who thinks there is a chance tax rates will go down in the future.
Given the likelihood rates will rise, it might be better to pay tax today rather than in the future when rates are higher.
2. You should not plan to be in a lower income tax bracket upon retirement
If you are planning to have a level of income at retirement that will result in you being in a lower income tax bracket, you may want to reexamine your investment objectives. The only reason someone would earn more income when they are in their 20s and 30s setting up a retirement account vs. when they are 65 or older would be because of poor investment choices and planning. While you may find yourself making slightly less money right after retirement as compared to right before, which likely will have been the height of your career, this should not hold true throughout the majority of your career. A better approach might be to assess ways to structure your operations and investments today in a tax-efficient manner instead of planning to make less money when you retire.
3. Penalty for early withdrawals
As a general rule, you are not permitted to access the money contributed to a 401k or IRA until you reach retirement age. If you do take early withdrawals, you will be subject to a 10% penalty unless an exception applies. Therefore, you have a limited ability to access these funds should you ever need additional cash before retirement.
4. Ordinary income tax rates apply to capital gains
All income in a 401k or IRA is taxed at ordinary income rates, regardless of the type of income. This means that all cash contributed to the account and any gains from investments made in the account are all going to be subject to tax at the higher ordinary income rates. A properly structured plan should have significant gains which otherwise would have been subject to the lower capital gains tax rates if the investments had been made outside your tax qualified account.
For example, if you took the money you were going to contribute to the plan and instead made direct investments in the stock market, those gains would be subject to capital gains tax. However, because they are made through your 401k or IRA, they are now subject to ordinary income tax rates. For those living in states that impose a state tax, you can be looking at tax rates of 50% or more on that income. This distinction is important due to the adverse estate tax implications that apply when a 401k or IRA is transferred through your estate upon death.
5. Estate tax implications
Retirement accounts are probably the worst vehicle for transferring wealth to your heirs. There are a number of adverse estate tax implications triggered.
- Heirs are subject to full tax at ordinary income tax rates on their share of the account inherited. Rather than getting a step-up in basis in the assets inside the account, such as a step-up to the fair market value of a stock on the date of death, your children will pay tax on 100% of the income in the account.
- As mentioned above, the entire value of the account is subject to tax at ordinary income tax rates.
- The heirs are generally required to take mandatory distributions and pay tax over a short period of time.
- The total amount in all retirement accounts will apply against your estate tax exclusion.
- There is limited flexibility to do estate tax planning with these accounts without triggering the deferred tax.
Non-Tax Disadvantages of 401ks and IRAs
Not only are 401ks and IRAs terrible from a tax perspective, they can also be bad investment vehicles.
- Lack of predictability
There is no way to predict what tax rates will be when you retire and start to take distributions from your plan. When the tax savings apply at the time money is contributed instead of when distributions are made, you are subject to uncertainty as to what amount in the plan is really your money and what amount belongs to the government.
2. Fees, fees, and more fees
These plans usually carry various different types of fees that drastically reduce the amount you are able to save and earn through compounding over time. Typical fees for managing a 401k can be 2%-3% or higher in some cases. Unless you have a self-managed account, you will also be paying fees to financial advisors to manage the account.
3. Lack of flexibility in investment options
The types of investments that can be made through a 401k or IRA are very limited in most cases. Use of a Roth-IRA typically provides more flexibility to invest in assets other than stocks and bonds, such as real estate, which may not otherwise be possible through a 401k plan.
4. Mandatory distributions
401ks and traditional IRAs have required mandatory distributions once you reach a certain age. Therefore, regardless of whether you need the money, you are required to take a distribution from your account and pay the associated tax. Other retirement planning tools such as Roth-IRAs do not have mandatory distribution requirements.
The One Time You Should Contribute
Notwithstanding the many disadvantages discussed above, you should still consider deferring to a 401k if your employer provides matching. Employer matching is free money and it would be hard to justify not taking advantage of free money in this case.
How Should I be Planning for Retirement?
There are other alternatives for retirement planning other than a 401k or traditional IRA.
Roth-IRAs or Roth-401ks
Converting your 401k or IRA to a Roth-IRA is usually a better option. However, the ability to contribute to a Roth-IRA is subject to limitations based on the level of income you make. Therefore, if you are a high earner, you may not be able to make annual contributions to a Roth-IRA account.
If you are subject to income limitations and cannot contribute to a Roth-IRA, it may be possible to do a backdoor Roth-IRA which would allow you to rollover funds in a traditional IRA to a Roth-IRA. You would be subject to tax on the full amount of income rolled over. However, all future gains and earnings grow tax-free once inside the Roth-IRA.
If you are subject to limitations and cannot otherwise contribute to a Roth-IRA or Roth-401k, the good news is that there are other mechanisms available that can accomplish the same objectives. There are other strategies that can achieve the same tax benefits if structured properly. Reach out to us at Winsmith Tax to find out what options might be available for you.
Please note that Winsmith Tax is not a financial advisory firm and is not authorized to provide financial investment advice. We encourage you to discuss any potential changes with your financial advisor before implementation.