Tax deferred accounts like 401(k)s, traditional IRAs, and other retirement plans can offer some retirement advantages, including the ability to grow your investments without immediately paying taxes on gains until withdrawals begin. While tax-deferred accounts can be a beneficial tool for building retirement savings, relying exclusively on them poses certain risks. Below are the key risks of focusing solely on tax-deferred accounts.

1. Higher Tax in Retirement

One of the primary risks of only investing in tax-deferred accounts is the uncertainty of your tax rate during retirement. While you may assume that your tax rate will be lower in retirement, this is not guaranteed. Several factors can cause tax rates to rise:

• Personal Income Needs: If you have high income needs in retirement or require large withdrawals from your tax-deferred accounts, your income in retirement could push you into a higher tax bracket than expected.
• Changes in Tax Policy: Tax rates are subject to political changes, and future governments may raise income tax rates to address national debt, fund social programs, or respond to fiscal challenges. This could result in higher taxes on your withdrawals than you anticipated when you initially invested. You are essentially entrusting the government not to take a large portion of your retirement savings.

By focusing solely on tax-deferred accounts, you are deferring taxes to an unknown future environment, which may result in a higher overall tax burden. This is known as tax risk. Your are essentially entrusting the government not to raise taxes or to create an environment where taxes must increased. This is a tall order no matter who you voted for.

2. Required Minimum Distributions (RMDs)

Tax deferred retirement accounts come with required minimum distributions (RMDs), which mandate that you start withdrawing a certain amount from your accounts each year after reaching a specific age (currently 73, increasing to 75 by 2033 under current U.S. laws). RMDs are based on life expectancy and account balances, and failure to take them can result in hefty penalties (currently up to 25% of the RMD amount).

The key risks related to RMDs include:

• Forcing Larger Withdrawals: RMDs may force you to take larger withdrawals than you need, which could increase your taxable income and push you into a higher tax bracket. This can be particularly problematic if you’re already receiving other income sources like Social Security or a pension.
• Loss of Tax Control: RMDs limit your flexibility to control when and how much you withdraw from tax-deferred accounts, reducing your ability to manage your taxes effectively during retirement.

3. No Tax Diversification

Investing only in tax deferred accounts lacks tax diversification, which can help manage your taxes more effectively in retirement. Tax diversification refers to having a mix of account types with different tax treatments, such as tax-deferred, tax-free (like Roth IRAs and Life Insurance), and taxable accounts. This provides you with more control over your taxable income in retirement.

If all your retirement savings are in tax deferred accounts, you will be fully subject to ordinary income tax rates on every withdrawal, which limits your ability to strategically minimize your taxes. For example, having a mix of both Tax Free Accounts and taxable brokerage accounts (capital gains tax treatment) can help you balance your tax liability in retirement.

4. Social Security Taxation

Withdrawals from tax deferred accounts are considered ordinary income, which can impact the taxation of your Social Security benefits. In the U.S., if your income exceeds certain thresholds, up to 85% of your Social Security benefits can become taxable.

Because withdrawals from traditional IRAs and 401(k)s are added to your income, they can push your income above the Social Security taxation thresholds, causing a portion of your benefits to be taxed. This effectively increases your tax burden, reducing the amount of retirement income you take home.

5. Limited Estate Planning Flexibility

Tax-deferred accounts can create estate planning challenges if your goal is to leave a financial legacy to heirs. When beneficiaries inherit a tax deferred account, they typically have to pay income taxes on withdrawals (unless they are inheriting a Roth account). The SECURE Act of 2019 eliminated the “stretch IRA” option for most non-spousal beneficiaries, requiring them to deplete the account within 10 years of the original owner’s death.

This can create a large tax burden for your heirs, especially if they are in their prime earning years and are forced to take significant distributions over a relatively short period, possibly pushing them into higher tax brackets.

6. Loss of Liquidity and Early Withdrawal Penalties

Tax-deferred accounts often come with penalties for early withdrawals. For example, if you take withdrawals from a traditional IRA or 401(k) before age 59½, you could face a 10% early withdrawal penalty in addition to paying ordinary income taxes on the amount withdrawn.

If you need access to funds before retirement age for emergencies or other financial needs, relying solely on tax deferred accounts could limit your options and lead to costly penalties. Having some investments in more liquid, non-retirement accounts provides greater flexibility and access to funds without incurring penalties.

7. Potential Impact of Inflation

While tax-deferred accounts provide tax benefits during the accumulation phase, they don’t necessarily protect you from the impact of inflation. Over long periods, inflation can erode the purchasing power of your retirement savings. If your retirement withdrawals are subject to taxes at ordinary income rates, you may need to withdraw even more to keep up with inflation, which can further increase your tax burden.

Additionally, inflationary pressures may prompt future governments to raise tax rates, compounding the effect of inflation on your savings and withdrawals.

8. State Tax Considerations

In addition to federal taxes, you may also be subject to state taxes on withdrawals from tax-deferred accounts. Some states offer favorable tax treatment for retirement income, while others tax it as ordinary income. If you plan to move in retirement, the tax treatment of withdrawals in your new state could significantly impact your financial situation.

Without tax diversification, you may find yourself more vulnerable to unfavorable state tax policies, especially if your tax-deferred withdrawals form the bulk of your income in retirement.

Conclusion

While tax deferred accounts are a powerful tool for retirement savings, relying solely on them comes with several risks. Higher taxes in retirement, required minimum distributions, lack of tax diversification, and the potential impact on Social Security benefits and estate planning are all important factors to consider. To mitigate these risks, it’s wise to diversify your investments across different account types, including Cash Value life insurance and Roth IRAs, taxable accounts, and tax-deferred accounts, giving you more flexibility and control over your financial situation in retirement.