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Traditional Retirement Savings: Why Tax-Deferred Accounts like 401(k)s May Be the Wrong Choice for Some Taxpayers Thumbnail

Traditional Retirement Savings: Why Tax-Deferred Accounts like 401(k)s May Be the Wrong Choice for Some Taxpayers

Tax-deferred is NOT Tax-free. - Danielle Woods, Attorney and Financial Advisor

Retirement is a Modern Construct

Did you know that the concept of saving for retirement has only been around for two generations?  In 1940, the average life expectancy for men was 60.8 years.  Women fared a bit better with an average life expectancy of 65.8.  Historically, people typically worked until they died or physically couldn’t work any longer. In 1935, when the Social Security Act was signed into law, citizens had to be 65 years old to receive Social Security, which meant a small percentage of people ever received payment.

Today, the average life expectancy for men and women is over 78 years, and non-disabled citizens can receive Social Security payments as early as age 62.  On top of that, the desire to retire “early” is growing like wildfire.  When considering the length of our lives and the cost of living compared with 1940, it’s no wonder we are having trouble keeping up with our retirement needs.

Traditional 401(k)s

For those of us who started working after the mid-1970’s and are not employed by a government entity, chances are your most obvious form of retirement savings was a 401(k) plan provided by your employer.   401(k) plans can and still do offer some very positive benefits in the form of automatic deposits and investing as well as possible free money from an employer match.   For millions of people around the country, this is the primary source of their retirement savings.  They have blindly set aside funds and watched them grow as if by magic.

One of the biggest selling points of 401(k)s, aside from the employer match, has been the tax savings that workers enjoy in the year of their contribution.  For a worker in the 24% income tax bracket who saves $10,000 in a traditional 401(k), the federal tax savings are $2400.  Even though the worker knows that this money will be taxed later, he congratulates himself for saving money now and assumes that his tax rate in retirement will be much lower.  Thus, he believes he has still saved money on tax.  For some, that may be true.  

Unfortunately, for an increasing number of workers, it is not true.  For good savers and/or disciplined investors, you could find your retirement account and your other sources of revenue (rental home, taxable savings, inheritances) growing much more than you ever dreamed.  That sounds wonderful until you realize that you’ve grown yourself right into a higher tax bracket than you ever thought possible.   

When this happens, the value of your savings must be reduced by the inevitable taxes you will pay.   With the increased collusion of health care plans and income tax brackets, you may also find yourself paying more for your healthcare premiums because of that hard-earned income level.   Those costs are now coming out of a fixed pot of money, not the replenished earnings of your working days.

With tax rates lower than they’ve been in decades, one should not assume that your future tax rate will be lower than it is now.

Pre-tax versus Post-Tax Savings:  Which is More Tax-Efficient?

Whether it makes sense to contribute to a pre-tax vehicle like a traditional 401(k) or a Roth account often depends on timing.  

If you are in a high income tax bracket (32% or higher) and intend to max out your 401(k) contributions, it may make perfect sense to do so.  If your tax rate is lower (12-24%), it might be better to use a Roth option.   For most clients, we recommend a bit of both over time.

Besides your current income tax bracket, other factors that may dictate the best option for you are:

  • The length of time that your account has to grow before withdrawals will be taken;
  • Future income or inheritance expectations;
  • Estate planning choices (beneficiaries); and
  • Healthcare needs and premium costs.

Keep in mind that nearly all contributions will be taxed whether now or later, but the income and gains from your investments are taxed very differently, if at all, depending on the account type.

Taxation of Earned Income and Investment Gains by Account Type*

Type of AccountContributionsIncome (Nonqualified)Realized Gains & Qualified Divs

Pre-Tax 401(k)

Future Income Tax Rate

Future Income Tax Rate

Future Income Tax Rate

Roth IRA or Roth 401(k)

Current Income Tax Rate

Never Taxed

Never Taxed

Taxable Brokerage

Current Income Tax Rate except for many inherited funds and gains on primary residence

Income Tax Rate

Short-Term:     Regular Income Tax Rate

Long-Term:     0-20% depending on Income

* Based on current tax laws as of January 2021.

Estate Tax, Inherited Assets and Step-up in Basis

Most of the country breathed a sigh of relief as the Estate Tax was all but abolished over the past several years.  Not that long ago, in 2008 for instance, the exemption amount was only $2 million. In 2021, if a person dies leaving an estate worth less than $11.7 million, then the heirs or beneficiaries of that estate will pay no estate tax.  When you consider how much wealthier some have become after a 10-year bull market, it is astounding how much tax has been avoided.

Estate tax aside, what about the assets you inherit?

Example 1.  If a person inherits their parents’ house and sells it immediately, there is no tax.

Example 2.  If a person inherits grandma’s IBM stock from 40 years ago and sells it immediately, there is no tax.

Why?  If a person inherits real estate or any other real asset (does not include retirement accounts and life insurance proceeds), they receive what is termed as a step-up in basis.

Bam-Bam Flintstone inherits his childhood home after his mother Wilma passes away.  His parents paid $20,000 for the home 50 years ago.  On the date Wilma’s death, the home was worth $220,000.  Bam-Bam decides that he does not need to live in the home and sells it for $220,000.  When Bam-Bam inherited the home, he received a step-up in basis (the market value on the date of Wilma’s death) vs. the original basis (how much his parents paid for the home). Bam-Bam now has $220,000 of tax-free income.

What if Wilma gifted Bam-Bam the house before she died? 

Gifts come with their original basis.  Therefore, Bam-Bam’s basis would be only $20,000.  When he sells the house for $220,000, he now has a long-term realized gain of $200,000.  Assuming his is in the 15% bracket for long-term gains, he would have to pay $30,000 in federal tax when he sells the house.

Retirement Accounts and the SECURE ACT

IRAs and Traditional 401(k)s are not real assets; they are retirement accounts.  Typically, no tax is paid on any of the money in those accounts until withdrawals are taken.  Therefore, when withdrawals occur, whether by the original owner or a beneficiary after the owner’s death, income tax is paid on those withdrawals at whatever bracket the taxpayer is in.

In 2020, the new SECURE ACT required that non-spouse beneficiaries must distribute 100% of the funds in an IRA or Traditional 401(k) within 10 years of the original owner’s death.  That is a huge and potentially expensive change from the previous law.  Prior to the SECURE ACT, a beneficiary could take a small amount each year, called a Required Minimum Distribution.   Otherwise, they could leave the account to grow and even pass it on to their own beneficiaries.


In 2019, Laverne is 50 years old and earns $35,000 per year.  Her friend Shirley passes away leaving her a $400,000 IRA.  Laverne lives modestly and takes just the required minimum distribution each year.  The account grows at a rate of 5% per year until Laverne’s death at the age of 80.   Over that 30-year period, Laverne has taken total withdrawals, net of federal tax of $659,200.  She has paid a total of $89,900 over the same period from those withdrawals.


In 2020, Laverne is 50 years old and earns $35,000 per year.  Her friend Shirley passes away leaving her a $400,000 IRA.  Laverne is required to withdraw all of the account within 10 years. Laverne chooses to take 20% of the market value each year until the final distribution in Year 10.  The account grows at a rate of 5% per year.  Over that 10-year period, Laverne has taken total withdrawals, net of federal tax of $387,300.  She has paid a total of $104,400 over the same period from those withdrawals.

In Laverne’s example, thanks to the SECURE ACT, the Federal Government gets $14,500 more tax in a much shorter period of time; and Laverne gets $271,900 less in net withdrawals!

Laverne’s Revenge

What can Laverne do?   Just because she is required to withdraw the money from the IRA, does not mean she is  required to spend it all.  Laverne is a fictional client of Propel Financial Advisors, LLC.   The tax savvy advisors at Propel tell Laverne to put $7,000 of her withdrawal each year into her Roth IRA  (for clients under the age of 50, the maximum contribution is $6,000) and invest the remaining withdrawal in her taxable brokerage account.

Laverne’s Roth contributions will grow and never be taxed, and she can leave that account to her beneficiaries tax-free as well.

Laverne’s Taxable brokerage account will also grow over time.  Laverne must pay regular income tax on the income (interest and dividend payments from her investments), but her long-term gains can be monitored by her advisor and only taken when it is efficient to do so.  If Laverne leaves the brokerage account to her beneficiaries, they will enjoy a step-up in basis and pay no tax on the assets that they sell right away.   Anything they choose to keep will have basis equaling the market value on the date of Laverne’s death.  Assuming Laverne paid less than the assets were worth on the date of her death, her beneficiaries will have tax-free income on those as well.

So What’s the Answer?

That answer will differ for each individual and may differ year-to-year depending on that individual’s circumstances.  As you can see, the rules surrounding financial investments are complex and regular planning is very important.  Making a mistake or missing a deadline can be far more costly than the annual fee you pay to your advisors at Propel.  If you are already a client and do not use our knowledge to help you with this planning, you are missing out on a great resource.  

Be sure to check in with us regularly, read our blogposts and take part in our webinars to stay up-to-date on how we are constantly working to help you be financially efficient.