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Tax Deferred Investing: The Unexpected Tax Trap

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Yeah! Tell me about it! I have never paid so much in taxes in my life, of course, I never made so much money in my life either. 

2017 my income was slightly over $200,000 because of the booming stock market and last year was about $100,000 because the stock market lost ground, but I still had to take about $30,000 RMD. 

It's funny how it works like that. You save and scrimp all of your life on a fairly low paying profession, and end up making almost as much money as MDs.  But I love it! And I would not change a thing. What is the alternative? Not tax defer? I loved both tax deferment and the regular Roth and would do it all over again with the massive mistakes I made, starting late, purchasing those horrible annuities, and paying $6000 in surrender costs. I may have learned later in life, but I did learn!  I have zero regrets. 

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Dan,

This is a valuable lesson that is often neglected on your site.

I, too, fell into this trap. I became aware at age 65 with 5 years until retirement and started rolling funds into a ROTH IRA from my 403b account. I was able to absorb the tax bite by using my conventional savings account. The entire 403b account was moved and, as you know, was unable to touch the 457b account because I was still employed. My full pension, plus SSA ( I was a classified employee) lifted me into a higher tax bracket. Currently, I have an untaxed Traditional IRA that will generate more income from the RMD. What a problem!!!!

Thanks for the reminder to all of the supersavers and longtimers!!! Bob

 

 

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While it is probably true for most Americans with no pension, for the rest of us the article debunks the long-held view that our incomes will be lower in retirement than while working. Our pension, which is also tax-deferred, along with our investments will push us to higher incomes. 

I wonder if our pension can go back to not being tax-deferred. It will never happen, but I wonder if it would be an advantage now.  

 

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I've had this opinion for several years now.

This is why I stopped investing in tax sheltered investments the minute Roth 403b 's /457b Roths became  available and why I have money in Roth IRA's and taxable accounts and  why I suggest going Roth all -the -way to the new folks. I know some may disagree based on math projections but who cares about the math projections. If you pay the taxes along the way you don't get straddled with huge tax hits and  don't suffer the shock and trauma of having to pay huge amounts of taxes at a time when you are not working. I'm owing taxes as we speak on dividends from my taxable accounts .. I can't wait until I hit 70 and start getting really soaked. At least in taxable accounts you have capital gains and qualified dividends which are taxed at a lower rate. Won't our RMD's be taxed as income?

 

If I could start over and a 403b Roth  would have been available thats how  I would have  invested all my retirement savings. Unfortunately I do own a hefty amount in tax sheltered investments and I am not looking forward to facing the music. I'm about 60% tax sheltered. But Yup I have two pensions (Wife and me) and our take home pension is currently lower than our pre-retirement income but once i start collecting SS we may be making as much as when we were working if not more.  Perhaps this is faulty logic but that's just how I see it and besides most investing is psychological and I'm just being psychological here I guess , even if the numbers go the opposite way and favor tax deferred investments. 

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The woman in the example in this article (Susan) has about the same pension and social security payout that I am projecting for myself.  I don't have anywhere near a million in tax deferred and I plan to retire at 57 or 58, with the help of taxable savings between age 57-59.5, 403 B between 59.5 and full retirement age (67), and Roth whenever extra is needed.

I would question why she would work until 70 with that much deferred and a good pension only to start huge RMDs immediately.  I would have retired sooner!  I realize she is probably just a hypothetical example to make a point.

 

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A large taxable income in retirement is a very good problem to have, don't you think?  The advantages of using a tax-deferred account for retirement savings are 1. you get an immediate, known tax reduction at the time of contribution and 2. that deduction allows (and encourages) many to contribute more than they would to a Roth.  I would not discourage anyone from contributing to the traditional tax-deferred accounts, including teachers expecting a pension.  Roths are also attractive, and if you are willing and able to max out a Roth, great, go for it.  Ditto for splitting the contributions between Trad and Roth, or rolling money into a Roth when you have a relatively low income (maybe during the retirement years before the RMDs kick in?).  But I bristle a bit at the suggestion that tax-deferred retirement saving is a questionable practice.  Are there really many retired folks who wish they had contributed less to such accounts?

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15 hours ago, whyme said:

A large taxable income in retirement is a very good problem to have, don't you think?  But I bristle a bit at the suggestion that tax-deferred retirement saving is a questionable practice.  Are there really many retired folks who wish they had contributed less to such accounts?

 

Thank you whyme! That's a great perspective and a great question. OF COURSE, nobody regrets saving in their tax-deferred accounts, and to suggest to young people not to use them at all because of higher taxes in the future is irresponsible and reprehensible. We don't know the future, and people will lower their taxes while working too. People forgot that there is a benefit for tax deferral now, it puts more money to work, so that you can pay those taxes in the future. That's been my experience. 

I temporarily forgot that paying higher taxes now than before is a reflection of where we are financial. All of us who frequent this board and the Bogleheads are in great shape financially and should be grateful. 

But not only financially it is an attitude that the government provides us with a civilization so that we don't kill each other for something to eat. Just two years ago when I got a $10,000 extra tax bill from the IRS in the mail because I had sold property that I had inherited from my family's farm, I paid it. My goodness, the bill was reasonable compared to what I got for FREE.

But I had never complained about taxes in my life (although I am surprised only by the fact that I had never made so much money during my working years counting a double income with my late spouse). Taxes is the price of a wonderful civilization we live in. For the most part, there is peace throughout the world. If one doesn't want to pay taxes, YEAH, live in the Dark Ages of Europe after the fall of the Romans in 500 until 1500. There was NO civilization and no taxes, so people had complete freedom from taxes but you never knew when the marauders would raid, steal, kill and rape your family, there was no 911! No police! No fire protection! 

I tell people exactly what you recommend, to use the tax-deferred retirement savings plan along with whatever Roth is available. And continue to save for your entire career. 

Thanks again whyme for your perspective, and to remind me to be grateful! 

Steve

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Thanks, Steve.

At the risk of persecuting the proverbial dead horse, I'll also point out that the hypothetical example in the article does not reflect the vast majority of real-world situations. 

1. "Susan" retires with virtually 100% salary replacement from pensions (she is obviously bringing in more than 30k total in Social Security, since part of the SS benefit is not taxed).

2. She retires at 70--maximizing SS and minimizing any chance to roll money into a Roth during the typically lower-tax years at the beginning of retirement before RMDs.

3. She has both a substantial public pension and full social security -- this is possible, but school employees in fifteen states (including Texas, Illinois, Massachusetts and my own California) do not contribute to Social Security at all, and if they qualify for benefits based on other employment, the amount of the benefit can be sharply reduced (via the "Windfall Elimination Provision").  The states that enroll school employees in SS tend to have lower pension benefits -- many have median benefits for new retirees hovering around $20,000/year.

4. While drawing a modest salary and paying into both pension systems, she managed to roll up one million in a 403b.  Good work, Susan, but if my anecdotal discussions about retirement with my colleagues are any indication, this is an unusual scenario (unless there's family money or another supplemental income source).

In other words, "Susan" is designed to push a point about Roth options, while conspicuously failing to note that only a tiny fraction of retirees are in her situation.  More typically public retirees' combined pension and social security will replace a relatively small portion of their final year earnings.  For one thing--I'm thinking now specifically of K-12 teachers, college professors and academic administrators in California's CALSTRS system, one of the most generous public pension systems--most retirees don't work 35-40 years in the same pension system, the point at which pensions approach full salary replacement.  It's far more common to retire in one's early sixties with something like 20-25 years tenure: in California, 20 years "service credit" (for someone at least 63 years old, it's less if you are younger) would translate to a pension (without survivor benefits) of 48% of base salary (based on the average of the three highest-pay years, so the actual percentage replaced would be a little lower).  There is a sort-of COLA with that, but it is weak, so the purchasing power is virtually guaranteed to erode over the years.  And, as mentioned above, no Social Security on top of this, at least not for the years of Calstrs covered employment.

In conclusion, Susan's colleagues should be encouraged to contribute as much as possible to those tax-deferred 403b accounts.

 

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All of you  frequent posters  on this board are  brilliant and  much more articulate than me. And I usually agree with all of you. And, I am sure Ed will come along and put me in my place with exacting numbers and Krow will also probably prove me wrong with his great research skills. Still I maintain that going 100% Roth in a 403b or 457b very  low cost plan when starting out and sticking with it  is the way to go.  Taxes are a terrible burden and they feel worse when you have to deal with them in bigger chunks  once you are no longer working. Better to pay as you go.

When did Joel Frank write this?  Is this a recent writing or was this in the 403bwise archives?  Just curious. I remember  Joel. He is a smart guy but quite challenging and sometimes overly aggressive.

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I did some research and from what I read: If you expect to to have more income in Retirement than you had while on the job, it's a tax trap to go 403b tax deferred and should go Roth. Granted some of us might not know how our future pans out but with pensions, social security, and savings all in play it would be foolish for a newbie to start out with tax deferral.

Here is a sample from an online article

  •  

Quote

 

  • Who should consider Roth Elective Deferrals? The decision to make Roth elective deferrals is personal but, in general, people who expect that their future retirement income will place them in a higher income tax bracket may benefit from this type of deferral. On the other hand, if you think your post-retirement tax bracket will be lower than your current tax bracket, you may be better off making tax-sheltered contributions.


 

 

 

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Tony,

You are funny! Nobody gets put in their place around here. LOL! 

I understand your position because your household with both of you have pensions, SS and investments, your tax bill is going to be high. But not everybody is as fortunate as you and your wife. Most retirees even teachers will have incomes lower in retirement because most teachers do not save extra. I will not discourage any young person to not tax-deferred. 

I would say to them that because the stock, bond and tax futures are unknown it is never "foolish" to tax defer some of your wages, do a regular Roth and/or a Roth 403b, 457b or 401k with some of your money too. The alternative is much worse, and that's what 70% of teachers do, and they do NOTHING. They rely on their pensions and SS, but here in California and other states, many teachers do not have SS.  

Steve

 

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This makes me think of a quote by Arthur Godfrey, "I'm proud to pay taxes in the United States; the only thing is, I could be just as proud for half the money".  😊

 

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