In some cases, individuals reach a point where deferring taxes to the max is counter-productive.
There are several reasons why this happens. For one thing, while deferring taxes is a good idea when personal tax rates are going down or staying the same, it’s likely that federal income tax rates have bottomed out and could start heading higher in the future. If this happens, you may be paying significantly higher tax rates on withdrawals from traditional IRAs during your retirement years.
Another thing to remember is that traditional IRAs impose restrictions on your ability to withdraw money before age 59 1/2 without being hit with a 10 percent penalty tax (although there are some exceptions). This can prevent you from taking advantage of some investment opportunities, such as certain real estate deals that cannot be financed with IRA money.
In addition, you could be charged a 50% penalty tax for failing to take required minimum distributions from your traditional IRAs each year after you reach age 70 1/2. (Roth IRAs set up in your name are not subject to the required minimum distribution rules for as long as you are alive and will never be hit with federal income taxes as long as you take out only qualified withdrawals after reaching age 59 1/2.)
Last but not least, profits earned in your traditional IRAs can never qualify for the reduced federal income tax rates on long-term capital gains and qualified dividends. Instead, all income accumulated in traditional IRAs will eventually be taxed at higher ordinary rates when you (or your heirs) take withdrawals. The current maximum federal rate on ordinary income is 39.6% (unchanged from 2016).
Bottom Line: For these reasons, some individuals may now be better off using taxable accounts, as opposed to tax-deferred accounts, to accumulate at least some of their retirement savings. Some individuals who are older than 59 1/2 might even benefit from taking some voluntary IRA withdrawals now rather than in future years when tax rates might be higher.
These decisions depend on how much tax deferral you already have.
One Size Does Not Fit All
Assessing whether your tax deferral is excessive, insufficient or just about right depends on a number of variables, such as your current marginal income tax rate, your expectations about future tax rates and the type of income or gains earned in your retirement savings accounts.
Each person’s situation is different, and there’s not always a clear right or wrong answer. However, if you conclude you have too much tax deferral — and thus are over-exposed to the possibility of higher future tax rates – you may want to consider some or all of the following strategies:
- Start making at least some of your annual retirement savings contributions to taxable accounts rather than traditional IRAs.
- If you’re a senior, withdraw money from your traditional IRAs sooner and faster than is necessary to comply with the required minimum distribution rules. That way, you pay taxes now at rates that may look low a few years later. You can reinvest the after-tax proceeds from IRA withdrawals in taxable accounts with the objective of earning lots of low-taxed long-term gains and qualified dividends. This strategy is most attractive if you would pay a maximum of 20% marginal federal tax rate on IRA withdrawals (unchanged from 2016). The 20% rate only affects singles with taxable income above $400,000, married joint-filing couples with income above $450,000, heads of households with income above $425,000, and married individuals who file separate returns with income above $225,000. Capital gains on investments held less than a year are short-term capital gains and taxed at ordinary income tax rates of 10, 15, 25, 28, 33, 35, or 39.6% in 2017 (and 2016).
- Take advantage of opportunities to contribute to Roth IRAs, Coverdell Education Savings Accounts, Section 529 college savings plans and health savings accounts. These accounts can be used to accumulate income that is free of federal taxes. While you might have too much tax-deferral, you can almost never have too much tax-free income.
- If you qualify, convert some or all of your traditional IRA balances into a Roth IRA.
Consult with your tax adviser to help determine the best course of action for wealth accumulation using traditional IRAs, other types of tax-deferred vehicles and taxable accounts.