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IRA/401(k) Tax Hike Considerations and Strategies for Generational Wealth Transfer

Feb. 22, 2021, 9:01 AM

The change in administration, coupled with Democrats’ razor thin control of the House and the Senate, may give way to a potential tax increase during Biden’s first term. As a result, considerations will need to be made for individual’s IRAs and 401(k)s, particularly if they plan to use these retirement vehicles as a tool for transferring wealth to the next generation, given possible changes to the tax environment.

Sometimes we see the future taxes that we’ll owe on our savings and investments, sometimes we don’t. For many current and future retirees with significant 401(k) and/or IRA balances, it may be more of the latter.

There are a few reasons why this might be the case:

Failing to Draw Down on Balances During Retirement: Many made pre-tax contributions to 401(k)s or took the upfront tax deduction on their IRA contributions. While this encourages contributions and investing, it also creates even more dollars that will be subject to tax in the future. The idea was you should contribute while working and take the tax deduction since you will be in a lower tax bracket when you withdraw the money in retirement. Indeed, this approach is beneficial for those who spend down their full IRA balances in retirement. The problem with this theory is that most older IRA owners are not drawing down their balances as indicated by the latest IRA update from the Investment Company Institute. The most recent update reports that 95% of IRA owners age 70 or older who took withdrawals in 2019 based them on the required minimum distribution (RMD) rules. When IRA balances are left invested in the capital markets, they often tend to continue to grow as investment gains often exceed RMD amounts. Further, the age IRA owners must begin RMDs increased from 70 1/2 to age 72 under The SECURE Act. Not to mention, proposed bills in Washington call for a further increase to age 75. Meanwhile, the IRS tables used to calculate withdrawals will change effective Jan. 1, 2022, and result in smaller RMD amounts. (RMDs were waived in 2020 due to Covid, so those assets will grow as well).

Elimination of a Key Benefit When Leaving IRA Assets to Heirs: The tax benefit of leaving IRA assets to heirs was eliminated by the passage of The SECURE Act in late 2019. Previously, inheritors of IRAs could further “stretch” tax deferral for decades as they could take RMDs over their lifetimes. Now however, with a few exceptions, inherited IRAs have to be drawn down within ten years. Prudential research shows that many IRA inheritors will wish to capitalize on additional tax deferral over that 10-year period, however the withdrawals that will eventually have to be made may be taxed at very high rates if beneficiaries are still in their working years. It is possible that these IRA dollars will be taxed at combined federal, state and local marginal tax rates of 40% or more, with some facing rates in excess of 50%. The reason is that many adults who inherit large IRAs will have significant incomes of their own and the IRA dollars withdrawn will be pushed into higher tax brackets. Hence the annual income for an IRA inheritor with a successful career and who is taking large IRA withdrawals will often be quite high.

Tax Increase for the Wealthy: President Biden has indicated that he wishes to propose higher taxes on those with income over $400,000. Perhaps, Congress won’t raise taxes for this group right away as there is an economic recovery that can’t be stalled. However, we should plan on it being discussed in Congress at some point if not this year, then certainly next year. Meanwhile, many states and local municipalities are suffering from severe budget shortfalls as a result of Covid-19 and are looking at revenue sources, including increasing taxes on the wealthy. Of course, IRA inheritors will be deemed wealthy in the years they make their withdrawals.

With these changes in mind, individuals may want to consider the following strategies to maximize building wealth while mitigating the potential for tax burdens:

  • Contribute Directly to a Roth 401(k): IRAs, 401(k)s, and other defined contribution plans are wonderful savings tools. But, if you are not likely to spend your retirement savings down in retirement, you may wish to plan differently. Contributing directly to a Roth 401(k) or a Backdoor Roth IRA may make sense.
  • Purchase Life Insurance: Allocating cash to a life insurance policy may make sense as the death benefit is typically tax-free to your heirs rather than seeing 40-55% of your hard-earned savings split with the government.
  • Consider Donating to Charity: If you are confident that you have more than you will ever likely need in your IRA, you could consider donating a portion to a charity in need. The Covid-19 recession has caused many families, colleges, and charitable organizations to be hurting for money. IRA owners age 70 1/2 and older can make a qualified charitable distribution of up to $100,000 annually to a 501(c)(3) organization and the amount will count against the annual RMD required to be withdrawn.

The bottom line is that the introduction of IRAs and 401(k)s has created some wealthy savers for retirement. The tax benefits were great, and the stock market has soared for the most part. But the rules are changing, and a huge tax liability may lie ahead. Planning to withdraw those dollars efficiently will require effective planning. If you are still working and your 401(k) has performed well, you may wish to diversify your approach going forward.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Prudential Financial, its affiliates, and their financial professionals do not render tax or legal advice. Please consult with your tax and legal advisors regarding your personal circumstances. Control number 1045435-00001-00

Jim Mahaney presently leads the Thought Leadership practice at Prudential Financial. With a recognized expertise in various financial planning topics, Jim is frequently quoted in The Wall Street Journal, The New York Times, Kiplinger, and other media outlets. He is also a contributor to Forbes. In his prior role, Jim invented the “File and Suspend” Social Security claiming strategy, which was called one of the smartest financial strategies available by Jonathan Clements of The Wall Street Journal in March of 2015. His paper, “Rethinking Social Security Claiming in a 401(k) World”, published by The Pension Research Council at Wharton, has been downloaded more times than any other paper in its history and is often cited in financial planning circles and the media. In addition, Jim holds three patents based on his design of retirement income products. His 2014 paper, “Financial Planning Considerations for Same-Sex Couples After Windsor” won the annual Retirement Income Communications Award from Investment News and the Retirement Income Industry Association. In 2016, The Women’s Institute for a Secure Retirement (WISER) awarded him the prestigious Hero Award for his groundbreaking research on helping divorced and widowed women improve their prospects for achieving financial security in retirement. Since its inauguration in 2013, Jim has sat on the Advisory Board for The Journal of Retirement.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.

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