Attack of the Tax Zombies!

 

ATTACK OF THE TAX ZOMBIES!

 

Terrifying Income Tax Issues are Lurking for Government Employees

 

Many public sector employees wisely make payroll contributions to a 457 deferred compensation savings plan.  The main reason for doing so is to save money for future retirement expenses.  Another reason public sector employees contribute to a 457 plan is to put off paying federal income taxes until retirement.  While saving for your retirement is without question a smart thing to do, making pre-tax contributions to a 457 plan may actually cause harm to your finances down the road. 

A popular belief among savers is making contributions to a 457 plan is a good idea because doing so reduces current taxable income and a household’s overall tax rate.  Since total income is oftentimes lower during your retirement years, the idea is 457 plan withdrawals will be taxed at a lower rate when taken during retirement.  Through this legal sleight of hand – avoiding taxes now and paying them later – many people believe they are getting one over on the tax man.  Well, not so fast!  As I have seen with countless numbers of individuals and married couples, during retirement the income tax rate can remain unchanged or even jump higher than what it was during the working years.  How is this possible?

There are three key reasons why many of you in the public sector are finding out the hard way about the flaw in your deferred compensation tax strategy.   First, many people in the public sector “retire” at a relatively young age and begin receiving monthly pension payments.  However, shortly after retirement, many of you either begin working again or start a business (or grow an existing one).  In the case of married couples, oftentimes the retiree’s spouse is employed or running her own business.  The combined income earned by the two, along with pension payments, could boost them into a higher tax bracket.

  Secondly, a retiree might decide to start withdrawing money from his 457 plan to cover living expenses or large purchases, which adds to taxable income.

                The third reason why many of you have experienced a tax shock – or one day might - is that you longer are itemizing deductions and have fewer dependents to claim.  If your mortgage has been paid off, you obviously have no interest payment deductions, which reduces the ability for those payments to move you down the tax rate ladder.  Although from a young age we are all taught to climb the ladder of success, when it comes to paying taxes, it is best to stay close to the lowest rung.  Lastly, if your children have gone off on their own and are no longer dependents, the ability to benefit from the tax breaks that they produced is eliminated. 

                The combination of 457 plan withdrawals, pension payments, income from a second career or business, and a spouse’s income can actually have a negative impact on your tax situation.  This is because the money from all of these various sources may result in your post-retirement income being the same or more than your pre-retirement income.  Now couple this with with potentially fewer tax deductions, and the end result is having a tax rate that is the same or higher than your pre-retirement rate.  In addition, keep in mind that tax rates are set to increase back to their pre-Tax Cuts and Jobs Act levels. 

               

Obviously, your intention all along was to save a lot in taxes now and pay less in retirement - not the same or more.  Sometimes the path to tax hell is paved with good intentions.  However, there are a few solutions to this potential problem, one of which will be outlined.

                The Roth IRA is a type of retirement account that allows you to save after-tax contributions for future expenses, including retirement.  Why is this type of account such a huge benefit for public sector employees?  Because during your working years, you can use tax deductions to lower your overall tax rate, then make after-tax contributions to the Roth IRA.  For example, imagine a married couple; the husband is age fifty and his wife is forty-five.  The husband is a police chief and will retire at the age of sixty.  His wife works in the private sector and will also retire at age sixty.  Currently, the couple earns $150,000, have three dependent children, and carry a home mortgage.  Given these facts, it is possible for the couple to bring their effective tax rate under 10%.  Now, fast forward ten years when the mortgage has been paid off, the kids are no longer dependents, and the husband has retired.  With the former police chief now drawing a pension and his wife still working, it is possible that the couple has a lower income, yet are paying taxes at a higher overall rate!  Worse yet, suppose the couple want to put a down payment on a second home or pay for their children’s weddings.  The husband might withdraw money from his 457 plan, which will be taxed at their current, possibly higher income tax rate. 

                The example that I provided plays out in real life all the time, but the negative tax consequences could have been avoided.  How?  By taking the tax hit now at a lower rate and funding a Roth IRA during the couple’s working years, they would have paid only, for example, 8% of their income to the IRS.  Then, when it came time to put the down payment on the second home or pay for their kids’ weddings, the distributions from the Roth IRA would have been totally tax free (assuming the couple followed the Roth IRA withdrawal rules).  An even better approach from a tax standpoint, provided the municipality allowed it, would have been for the husband to make contributions to his 457 plan with a designated Roth account (DRAC).  While the Roth IRA allows $5,500 of contributions, a 457 plan with a DRAC allows contributions of $17,500 (2013 figures are are subject to change).   Lastly, it may make sense to consider doing a Roth IRA conversion, considering that tax rates are scheduled to go up in 2026.

                Contributions to a Roth IRA or DRAC during your working years can be one of the most tax-efficient ways of saving for retirement.  Doing a Roth IRA conversion is a solid, potentially tax-saving strategy too is done the right way.  Of course, making pre-tax contributions to a 457 plan can also be tax-efficient; it just depends upon your personal circumstance.  Therefore, I encourage you to thoroughly review your income tax situation to determine whether it is better for you to make pre-tax or post-tax contributions to available retirement plans.  Although the example that I provided is fairly straightforward, in reality, there are many moving parts involved with tax and retirement strategies and it would serve your best interests to seek the advice of a competent, experienced financial planner and credentialed tax professional before deciding on making pre-tax or post-tax contributions to your retirement accounts or executing a Roth IRA conversion.