At Paraclete Wealth Management, we believe our commitment to educating our clients sets us apart. The following content on tax-deferred retirement plans is partially excerpted from The Power of Zero by David McKnight, and we believe you’ll find it eye-opening as you plan for a tax-efficient retirement.
So many clients come through our doors having followed advice from so-called financial gurus who tell them it’s okay to have all their assets in tax-deferred accounts because they’ll be in a lower tax bracket in retirement. Of course, this is a faulty assumption, and below we further explore the pitfalls of the tax-deferred bucket, referencing Joseph Heller’s Catch-22. The underlying theme of this famous novel can help shed light on the true nature of tax-deferred retirement plans.
Catch-22
The main protagonist in Catch-22 is named Yossarian. He and his friends serve in bomber crews during World War II, stationed at an air base off the coast of Italy. One by one, his friends fly into battle, get shot down, and never come back.
Soon, Yossarian begins to realize that if he continues going on these bombing missions, he too will be shot down. So, he studies the Air Force regulations and comes across Rule 22. It states that if a pilot can successfully plead insanity, he can be honorably discharged. However, the very act of wanting to avoid dangerous missions proves he’s sane—so he must keep flying them.
Sound familiar? It’s a situation with no favorable outcome, making tax-deferred retirement accounts feel like a modern-day Catch-22.
The Tax-Deferred Dilemma
The Rock: Required Minimum Distributions (RMDs)
The IRS eventually wants its share of your tax-deferred savings. Starting at age 73 in 2025, you’re required to begin taking RMDs from traditional IRAs and 401(k)s. If you fail to take the required amount, you could be penalized with an excise tax—currently 25% of the RMD shortfall (down from the prior 50%, but still significant). You’ll also owe income taxes on the amount withdrawn.
The Hard Place: Taxing Your Social Security
On the other hand, taking out too much from your tax-deferred accounts can bump your income up and make up to 85% of your Social Security benefits taxable. In essence, withdrawing too little results in penalties, while withdrawing too much results in greater tax exposure.
The Bottom Line on Tax-Deferred Accounts
If you take out too little, you risk a steep penalty. If you take out too much, you increase your taxable income and potentially reduce your Social Security benefit’s value. That’s the catch-22 of tax-deferred accounts.
Deciding how much to contribute to these accounts often comes down to your expectations about future tax rates. If you believe tax rates will be lower in the future, then traditional tax-deferred accounts may make sense. If you believe rates are likely to increase—even slightly—then reducing your exposure to future taxes by shifting assets elsewhere could be a more thoughtful strategy.
A Smarter Approach to Rethinking Tax-Deferred Retirement Accounts
At Paraclete Wealth Management, we guide clients through strategies designed to help reduce future tax risk. If this article prompted you to reconsider your tax-deferred strategy and you’re not yet a client, we invite you to schedule a complimentary strategy session. Let’s explore how a tax-aware retirement plan could better align with your goals and reduce exposure to future tax increases. We look forward to hearing from you!