Diversify Your Retirement Plan Strategy

Diversify Your Retirement Plan Strategy

| December 13, 2022
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Two people can look at a Rorschach ink blot and one will see a refined beautiful woman, and another will see an old spinster. You can also look at a retirement account and see all the good points or look at it from a different perspective and see all the shortcomings.

It's easy to find information on the advantages of a pre-tax retirement account like a traditional IRA or a 401(k), including the tax savings, the tax deferred growth, and providing a source of retirement income.

What you don't hear about as often are the disadvantages of such accounts. Knowing what they are may help you strike a more sensible balance in how you save money.

Different Estate Plans

For starters, pre-tax retirement plans are not directly regulated by an estate plan like a will or your trust.

The unofficial estate plan for your retirement account is what is known as “the beneficiary election form”.  In most cases, the attorney that is drafting a will or a trust doesn't get involved in properly titling names on this beneficiary form. Because of this, often the heirs named in an estate plan are “not” titled the same as they are on a beneficiary form, which can cause problems.

For example, when an attorney drafts a trust, they will often use “per stirpes” language, which keeps each heir’s share of an inheritance in their bloodline, if they pass prematurely.

Because the typical retirement plan owner titles their own beneficiary form without the help of an attorney, very rarely are they aware of such language.

For instance, if the original retirement plan owner and one of the beneficiaries died simultaneously in a car wreck without per stripes language, the deceased beneficiary’s share would go to the surviving co-beneficiaries instead of the deceased beneficiary’s children.

Also keep in mind that if you update your heirs in your estate plan due to divorce, birth, death, or something else, it does not automatically update your beneficiaries on your retirement account.  This could result in the wrong person or persons getting your retirement assets at your death, like an ex-spouse, if you forget to update your beneficiary form.

Tax Advantages in Taxable Accounts

Pre-tax retirement plans never receive the more favorable long-term capital gains tax treatment.  To illustrate, a stock purchased for $10,000 in a taxable account, that grows to $100,000 over the next 20 years and is then sold, will trigger a $90,000 long term capital gain.

In a 24% tax bracket, instead of paying 24% of the $90,000 in gains which would cost $21,600, it would be taxed at a 15% long-term capital gain tax rate which would result in a reduced tax of $13,500.

However, if the same thing was done inside a pre-tax retirement account, you would not receive the more favorable long-term capital gain tax treatment if you took the sales proceeds out of the account.

In this case, using the same example, the full $100,000 would be taxed in the 24% tax bracket, resulting in a much larger tax hit of $24,000.

In a similar scenario where a stock is purchased for $10,000 in a taxable account and appreciates to $100,000, and the owner of the stock passes away before the stock is liquidated, all taxable appreciation up to the date of death is forgiven when the heirs sell it. This can result in huge tax savings where a lot of highly appreciated investment securities are involved.

This would not be the case if the same stock was owned inside a pre-tax retirement plan.  When the beneficiaries sell their share of stock after the original owner’s death, and withdraw the proceeds, they will be fully taxable as ordinary income.

Better Gift Vehicle

Money in a company retirement plan or pre-tax IRA cannot be gifted at least directly, as would be the case in a non-retirement account. 

In 2022, the annual gift tax exclusion is $16,000.  This means a gift of up to $16,000 can be made to as many people as you like without having to deal with gift tax consequences.  The gift is not taxable to the donor when made, nor is it considered taxable income to the recipient.

However, money taken out of a pre-tax retirement account to make such a gift, would trigger ordinary income tax upon withdrawal.

In a 22% tax bracket $3,520 in taxes would have to be paid upon withdrawal of the $16,000, before the gift could be made to recipients, such as your children. 

RMDs

Pre-tax retirement accounts also have taxable required minimum distributions that you must start taking in the year you turn age 72 and even sooner in the case of a pre-tax inherited IRA.

There are no such forced distributions that trigger tax on other assets. 

Striking Balance

While these disadvantages don't invalidate the wisdom of putting money in a retirement account, they do suggest that there might be a need to strike a better balance between funding a retirement account and a taxable account to diversify your tax strategies.

 

This article is for informational purposes only. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice as individual situations will vary. For specific advice about your situation, please consult with a lawyer, tax or financial professional. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation.

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