Why Your Retirement Savings Is Smaller Than It Looks

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There's a financial crisis looming for the millions of Americans hoping to retire. With more than half of all workers saving for retirement having $25,000 or less squirreled away in their nest eggs, it's clear that most people are woefully unprepared for the financial realities of living off Social Security, their life savings, and any supplemental income they may be fortunate enough to have.

Yet even if you've succeeded in building up a bigger nest egg, you can't assume that you have it made. If you're like most people, your retirement account balance dramatically exceeds the actual financial resources you have at your disposal, for one simple reason: The IRS is waiting in the wings to get its long-awaited pound of flesh.

Understanding retirement taxation
We've all heard about the benefits of saving for retirement using tax-favored accounts like IRAs and 401(k) plans. By setting aside pre-tax money in those accounts, you get an up-front tax deduction on your current-year return that reduces your tax bill or entitles you to a larger refund. With IRA contributions being one of the few ways you can decrease your tax liability after the tax year has already ended -- you can make a 2012 contribution to an IRA up until April 15 -- many taxpayers see the tax deduction as the primary reason for funding an IRA in the first place.

In addition to that up-front benefit, IRA and 401(k) account holders don't have to pay taxes on the income from those accounts, either. Instead, as long as the money stays in the retirement account, Uncle Sam has to wait patiently, allowing assets to grow on a tax-deferred basis.

But eventually, you'll need your retirement money, and that's when you'll feel the big tax hit. When you withdraw money from a traditional IRA or 401(k), the withdrawn amount gets added to your taxable income. Typically, it's subject to tax both federally and at the state level.

Often, that ends up being a net win. Deductions you get during your career when your tax rates are high can be worth more than the taxes you have to pay at lower rates when your retirement income is low. But higher taxable income from IRA and 401(k) withdrawals can also have unintended secondary effects, such as lifting your income above the threshold at which a large chunk of your Social Security benefits become subject to tax as well. And regardless, having even 15% to 25% of your retirement-account balances go to pay income taxes is a major haircut for most savers' modest nest eggs.

The solution
In order to fight this, the obvious first step is to take potential tax liability from your retirement assets into account when you're planning how much you need in order to retire. That can prevent you from being overly optimistic and retiring sooner than you should.

But it's also important to have a diversified portfolio of assets that includes some investments held in ordinary accounts. While retirement accounts are a great place for high-tax investments like mortgage REITs and high-yield bonds, low-tax investments that you can buy and hold for decades are often better to hold in a taxable account than in a regular IRA. For instance, (NASDAQ: PCLN  ) continues to dominate the travel-portal space and has started cashing in on the purchasing power of a rising consumer class in international markets. Panera Bread (NASDAQ: PNRA  ) was early in tapping into the trend toward healthier food offerings yet has been able to hold its margins up well despite food inflation pressures. Finally, Netflix (NASDAQ: NFLX  ) has overcome huge challenges and has started lining up the great content it will need to compete against much larger rivals in the years to come. All three of these companies pay no dividend, yet they've produced huge capital gains that qualify for low long-term gains rates when held in taxable accounts.

In addition, certain types of assets do better in taxable accounts. Municipal bond investments iShares S&P National Municipal ETF (NYSEMKT: MUB  ) and Nuveen Municipal Value (NYSE: NUV  ) , for instance, don't fit in IRAs because their income is already tax-free. In fact, you can turn tax-free income into taxable distributions if you invest in munis in an IRA.

Another smart hedge is having some money in Roth retirement accounts. With Roths, you can take retirement money out with no tax consequences -- a valuable tool to have at your disposal if you need to keep your taxable income down.

Finally, be aware of the overhang of potentially taxable IRA money before you need it. Sometimes, taking withdrawals even before you retire can be smart, if you've reached age 59 1/2 and are getting taxed at a low rate.

Don't get fooled
Even if you have an impressive retirement account balance, it may not give you the financial security that you need. Be tax-smart about your retirement assets, and you'll have a much better chance of having a comfortable retirement.

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Read/Post Comments (4) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 21, 2013, at 12:32 PM, Fool wrote:

    Thanks for another great article about retirement savings Dan.

    If all things were equal (i.e. the assumptions around tax rates and annual equity returns), I could see how 401(k) and Roth IRAs would be identical. It's a wash whether you pay the tax upfront or carry it forward, since your final cash balance would be the same either way (again, assuming all else equal).

    But just to add my 2 cents, it seems like you get to avoid a lot of the uncertainty around tax rates (which are completely out of our control) and get a lot more investment options with the Roth. I've twice taken advantage of the opportunity to convert 401-k assets over to a Roth for the long run.

  • Report this Comment On February 21, 2013, at 4:44 PM, ctstone wrote:

    Dan, you suggest investing in Netflix for a retirement account. Really? A stock that has run up to a PE over 600 because it made a small, unexpected profit last quarter? A speculative stock that lost 83% of its value from July 2011 to August 2012? I think this advice stinks so badly that it taints the entire article. Sorry.

  • Report this Comment On February 21, 2013, at 4:57 PM, TMFGalagan wrote:

    @TXinvestor82 - Agreed that the Roth takes uncertainty out of the mix. But you *do* have *some* control over taxes, in the sense that in retirement, you may be able to structure your withdrawals in a way that reduces your taxes compared to what you paid during the best earning years of your career.


    dan (TMF Galagan)

  • Report this Comment On February 21, 2013, at 5:46 PM, boydlemon wrote:

    This is all good advice. Obviously, financial planning is key to a fulfilling retirement. But I want to call to the attention of baby boomers and anyone planning retirement or recently retired that emotional planning is important too. Going from a full time job to no job may seem ideal, but it is an enormous and difficult adjustment. Too many retired people end up feeling useless, with no purpose. Many suffer from episodic depression as a result, making what could be the best time of their lives, the worst time. Prepare yourself by finding a passion to pursue during retirement.

    Boyd Lemon-Author of "Retirement: A Memoir and Guide" (December 1, 2012); Eat, Walk, Write: An American Senior’s Year of Adventure in Paris and Tuscany (2011); and 5 other books. Information, reviews and excerpts:

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