There are two trains of thought in the current economy: historical boom or historical bust. In the wake of the great financial disaster of 2007 and 2008, the general consensus among investors is to be cautiously optimistic about 2010.
The collateral damage left from the market crash has the largest generation in American history re-evaluating their financial objectives. Market volatility has created a blinder for many investors. Beyond the peaks and valleys in front of us lurks a potential problem so great it could potentially crush the great American retirement.
“We focus on the accumulation phase of retirement planning, but forget that we save so we can spend,” says Chris Kichurchak, president of Noble Financial Group. “Retirement is the spending phase of our planning process.”
Smart Business spoke with Kichurchak about retirement planning and the looming tax problems lying ahead for investors.
How have economic issues affected the outlook for future retirees?
One of the original IRA tenets held that deferring tax until retirement was advantageous because funds would likely be taxed at a lower rate. That is no longer self-evident. You may live out your retirement in the same or a higher tax bracket if you accumulate a respectable retirement nest egg. Because of the current levels of government spending, previous and growing government debt levels, and a diminishing work force, effective tax rates will likely be higher in the future.
As many people approach retirement, they don’t have mortgage interest deductions, they can’t claim their children as dependents, and they are no longer contributing to tax-deductible retirement plans. Thus, in retirement, they find themselves in the same (or higher) tax bracket as they were during their earning years, despite having a lower income. It doesn’t make sense to postpone tax for some perceived advantage in the future. Your IRA, pension and 401(k) benefits will probably be taxable at a higher rate at retirement.
So how will these issues affect investors’ money?
To gain a clear understanding of the tax trap that investors have got themselves into, we first need to understand the four phases of retirement planning and how each investment vehicle reacts during each phase.
The first phase of retirement planning is the contribution phase, when we make deposits into some type of investment or savings vehicle. For example, if we make a contribution into a qualified plan, such as an IRA or 401(k), under IRS tax code we may deduct those deposits from our gross income on our tax return. Contributions made to nonqualified vehicles are made with after-tax dollars.
The second phase is the accumulation phase, when we accrue money with compound interest, appreciation, or reinvestment of dividends or capital gains. Depending on the type of vehicle the investor chooses, the accrued interest, appreciation and reinvested dividends or capital gains may be realized or unrealized as the account grows. For example, money accumulates in qualified vehicles tax-deferred. Some nonqualified vehicles may also grow tax-deferred or even tax-free, while others get taxed as they go.
The third phase is the distribution phase. This is truly the most important phase of the retirement planning process. Each retirement vehicle will react differently during this phase. Depending on the type of vehicle chosen, distributions can be tax free, taxed on growth or fully taxed as income. These vehicles may also dictate the level of taxation of Social Security earnings. For example, qualified vehicles are fully taxed as income as they are spent. Nonqualified vehicles can be taxed anywhere from ordinary income on gains to tax free.
The final phase is the transfer phase. Some people are not concerned about leaving a legacy, but the fact of the matter is, we should hope to leave a legacy. If we leave a legacy that means that we didn’t run out of money while we were retired. Qualified vehicles pass as taxable income to our heirs and are even potentially taxed a second time on the estate level if passed after 2010. Some nonqualified vehicles transfer income tax free.