Back in 1974, the ERISA Act established the legal base for the IRAs we all know and love. Just 4 years later, the legislation that created the 401k was born. Since that time, most Americans have squirreled away their hard-earned dollars into what we now refer to as “qualified” accounts. Have you ever weighed the cost of saving in these kinds of accounts? We regularly see retirees taking money from their IRAs and 401ks and then taking out additional funds to cover the taxes on their distributions. In this article, we examine the use of qualified accounts and discuss the savings versus the costs—a few notes before we get to the math and scenarios. There is no universal truth here. All families and situations are unique. What works for you may be completely opposite of what works for anyone else. Also, before implementing any strategy discussed here, you should consult with a tax professional and financial advisor. Finally, when referring to 401k/IRA, note that the vast majority of the rules that apply to these account types apply to a whole host of other qualified saving plans like 403b, SEPP, SIMPLE IRAS, Solo 401k, and several others. We will simply refer to the more common varieties.
IRA and 401k Mechanics
First, a quick refresher on the mechanics of qualified accounts. For a good visual, think about farming. Farmers plant small seeds, then hopefully harvest a large crop they sell later in the season. Pretax plans work in a similar way. As we work, many of us get to participate in IRAS and various types of workplace savings plans. As we contribute small regular sums to the pretax plans, we get to take a tax deduction for the contribution. In the analogy, we are excused from the taxes on the seeds we plant in the working years. As time passes, we, like the farmer, hope that our contributions grow and become much larger over time. Between the ages of 59.5 and 72, we gain unfettered access to these saved dollars. As we start to harvest the crops we have sewn over a lifetime of savings, the IRS requires that we pay the tax that we were excused from earlier in our careers. In short, the IRS taxes the crops and not the seeds on IRA/401k accounts. So, the question that I began to consider is, are the savings on the seeds worth the taxes on the crop later? I think the original intention was to give deductions at the height of most folks earning years and then collect taxes in retirement when tax brackets may fall due to a lack of wage income. In my experience, many families don’t experience this falling income level, so they end up taking distributions in the same tax brackets as when they worked.
Let’s review an individual with a long career of 40 years. If they contributed the max each year to a 401k plan, they would have contributed about $610,096 in 40 years¹(excluding any company matching). However, it is never this straightforward, and the tax codes typically change in each governmental regime. As an example, the current tax code is set to expire at the end of 2025 without further work by the government. The median annual income for 2022, according to the US Census, is about $71,000². Let’s assume a 24% marginal tax bracket for the purpose of deduction and later distribution. If you captured a 24% deduction on the contributions over the 40 years, that amount is roughly $146,423. If you walk into retirement with roughly $610,096 and made your normal Required Minimum Deductions (RMDs), what is the tax cost of exit?
| Total Contributions From 1982-2022 |
Tax Rate of 24% |
Estimated Tax Savings |
| $610,096 | 0.24% |
$146,423 |
Let’s assume we can stay in the 24% marginal bracket, and let’s assume a 9% average return. That is just less than the S&P 500 Index average since 1926, which is reported to be 10.13%³. Based on these assumptions, if you calculate your RMDs based on IRS Publication 590-B, your RMD total would be approximately $1,557,055 (See Appendix A) from the account if you lived to 99 years of age. The tax on that might be roughly $394,263 (See Appendix A). Remember, the possible savings for contributions were roughly $146,423 (See Appendix B). That is a big spread. In percentage terms, the tax could be as much as 269% of the savings. As described earlier, many “gross up” the RMD and ask for the tax to be covered by taking a little more out. In that scenario, again, in the 24% tax bracket, you might remove $ 2,069,554 (See Appendix A) in grossed-up RMDs with an estimated tax total of $496,592 (See Appendix A). If you remove the grossed-up RMD, then your exit cost is 339% of your entry savings.
| Starting Value at 72: $610,096 |
Normal RMD |
Grossed up RMD |
| Estimated Tax Savings | $146,423 | $146,423 |
| Estimated Distribution Tax | $394,263 | $496,692 |
| Difference in Percentage | 269% | 339% |
Most of us have seen our portfolios rise dramatically since 2008. With tax legislation changing for RMDs as well as inheritance taxes, it is very important to consider the tax ramifications of your family’s choices. Is having a large, qualified savings account bad? No, far from it. This isn’t a binary universal truth discussion. This is about really thinking through your financial plan and considering the current, future, and inheritance taxes you may face. It is our belief that leading up to retirement or even in retirement, money should be somewhat considered by its tax status. Consider the following:
| Account Type |
Timing of Tax |
Rate of Taxation |
| IRA/ 401k (Qualified Accounts) | At the time of use | Highest marginal |
| Brokerage Accounts | Point of sale | Graduated Capital Gain |
| Roth IRA | None | None |
The industry refers to these accounts and their differences by tax characterization. Pretax, post-tax, and brokerage are the main designations here. So, if you deliberately save in all three account types, you can hopefully pay the distribution tax from maybe a Roth or Brokerage account. By saving in more than just your qualified accounts, you may be able to lower the tax costs at the removal of these qualified accounts, ensuring that your money lasts longer and accomplishes more of your goals.
Inheritance Taxes
The final thought here is about changing inheritance taxes. For many years everyone was allowed to inherit money from IRA/401k accounts and then slowly drain them over time through RMDs. Those rules have changed. Many inheritors will now have to drain the accounts in the 10 years following the depositor’s death. This change accelerates a tax that could have taken 20-30 years to fully collect into a short decade. As we discussed in a previous article about Roth conversion, this forced income tax could raise the tax costs on the inheritor. The second issue here is that IRA assets can be double taxed in certain large estates. They can be taxed both as an asset and as income with respect to the decedent. Qualified assets have long been a chore to address from an estate liquidity perspective. Thankfully even if all the assets are qualified, there are still strategies to help alleviate these issues, but there is something to be said for the old southern adage, “An ounce of prevention is worth a pound of cure”. We believe that saving deliberately in IRA/401k, Roth IRA, and Brokerage accounts can go a long way in moderating the tax costs of using your hard-earned savings.
CONCLUSION
In conclusion, consider your income strategy later in life. Work with your advisors on tax-sensitive solutions to save now, or consider mapping out Roth conversions over time to slow or lessen the tax costs of exiting your IRA/401k plans. Smart planning now could save you money and lower the tax costs of inheritances for your heirs. Please reach out to us with any questions or concerns. Possibly saving more in taxes should be reason enough for us all to use a critical eye on our approach.