Tax Savings and Tax Deferrals

By Jason Watson, CPA
Posted Saturday, September 28, 2024

Many taxpayers walk into our offices at WCG CPAs & Advisors and tell us they want to pay fewer taxes. Who doesn’t? We usually chuckle, and tell the client that he or she is the only one and it is sooooo refreshing to hear someone want to pay fewer taxes. Sorry for being snarky, but taxes are a way of life. Yes, our job is to have you pay the least amount of taxes permitted by law and not a dollar more, but that isn’t the only objective.

Tax savings comes in four variants- you can lie, cheat and steal, or you can understand the allowances, deductions and credits alongside the wiggle room afforded by the IRS code. We prefer the latter of course although the audit rate risk of 0.4% for S Corps and partnerships makes it all too tempting. Darn laws and ethics!

However, notice how 401k plans, IRAs, and other tax-deferred vehicles are not listed as one of the four ways to save taxes within self-employed retirement plans. A tax deferral is not automatically a tax-savings technique- it might be. It might not be. In true accountant fashion, it depends.

This is a real-life case- we have two Boeing engineers who saved about $1 million in the company 401k plan. The employee deferrals were all pre-tax, so they avoided about $250,000 in taxes since they were in the 25% marginal tax rate. Not bad.

However, they currently have four children, a house mortgage, and the usual tax deductions of a household of this size and age. When this couple retires in 2025, their marginal tax rate will increase to 32% due to their pension income and other income sources, and the dramatic reduction in tax deductions and credits.

So, they saved at 25% and they will pay it back at 32%. Bummer. But wait! There is more to the story. Just like Paul Harvey, there is a page 2, or in the case of this book, on the next page. Yes, we are dating ourselves by referring to Paul Harvey but when that is all your parents listened to in the car, it is hard to forget.

What about all tax deferrals? Where does that money go? Usually to buy stuff like cars, vacations, food, and other consumables which don’t offer a return on investment. But what if this same couple invested the current tax deferrals into a conservative portfolio which yields a nice 5% rate of return (after tax consequence)? Things tilt in their favor- so we are back to having a tax benefit from tax deferrals. Huh?

The following is a ridiculously overly simplified table to demonstrate what we are talking about. Here are the assumptions-

• Defer $23,000 (for the 2024 tax year) per year for 10 years.

• Marginal tax rate is 22% during wage earning years.

• Rate of return on investing tax deferral savings is 5% net of taxes.

Year	Defer		Tax Savings @ 22%		Growth at 5%
1	23,000		5,060		5,313
2	23,000		5,060		10,892
3	23,000		5,060		16,749
4	23,000		5,060		22,900
5	23,000		5,060		29,358
6	23,000		5,060		36,139
7	23,000		5,060		43,258
8	23,000		5,060		50,734
9	23,000		5,060		58,584
10	23,000		5,060		66,826
Totals	230,000		50,600		66,826

A quick recap- you deferred $230,000 and deferred $50,600 in taxes. That deferral grew to $66,826 because you invested it in a safe 5% investment portfolio. Great. What does this do?

Here is the realized savings for a 22% marginal tax rate during retirement-

Withdrawals Taxed at 22%	50,600
Growth on Tax Savings	66,826
Realized Savings (difference)	16,226

If your marginal tax rate remains the same at 22% you still see a savings of $16,226 as shown above. Again, this is predicated on you taking the tax you normally would have paid and investing it wisely. Not all of us are this disciplined.

But if your marginal tax rate increases from 22% to 35%, your savings is zero. Granted, to jump 13% in marginal tax rate between wage earning years and retirement years seems rare, but you get the point.

The moral of the story is this. Yes, tax deferrals can lead to tax savings, but you must work the system and be disciplined. Not just today, but for several years, and you need a jump in marginal tax rate that is 9% or less (in general). Assuming you have an increase at all. See below-

Withdrawals Taxed at 35%	73,600
Growth on Tax Savings	66,826
Realized Loss (difference)	-6,774

The bummer of this table is the leap from 22% to 32% marginal tax rate. Recall that you deferred tax at the 22% marginal tax rate. If you pay it back at 22%, then you are golden. You pay it back at 32% (the next marginal tax rate), then you lose money.

What should you do? Financial planning and review with your financial advisor are a must. Generally, we see people in the 10 and 12% marginal taxes doing post-tax (Roth). We see people in the 32, 35 and 37% marginal tax rates doing pre-tax. Then, we see people in the 22 and 24% marginal tax rates doing a mixture of post-tax and pre-tax retirement contributions.

We’ll talk about the built-in hedge with the employer (your business) contributions which must be pre-tax. In other words, your 401k deferrals are Roth (post-tax) and your employer contributions are pre-tax. This combination is a great hedge.

There is also the RMD angle. RMD is a common TLA (three letter acronym) tossed around at bingo parlors and country clubs, and stands for required minimum distributions. In a nutshell, the IRS forces you to take out a portion of your pre-tax retirement savings every year so they can collect on the IOU you gave them several years ago.

RMD calculations are simple. You take your age, find your life expectancy factor and divide that into your aggregate pre-tax account balance. Do you remember science class and discussing a molecule’s half-life? RMDs are very similar- over the course of retirement, you must withdraw pre-tax retirement dollars, but the calculus doesn’t force you to take it all out over your lifetime. It always has some factor of your age, and depending on your frugality you might die with a pile of money since the minimum leaves behind a lot.

The IRS released updated life expectancy tables and distribution periods in November 2020. The last time this was done was nearly 20 years ago! Here is snippet of the IRS RMD table which can be found in the appendix of IRS Publication 590-B (the most recent is for the 2022 tax year)-

Age	Factor
72	27.4
75	24.6
80	20.2
85	16.0
90	12.2

So, if you are 75 years old and had $1M in pre-tax money, your RMD would be $40,650 ($1,000,000 divided by 24.6).

What does this have to do with tax deferrals becoming tax savings? At some point you die, and if you only take out the minimum amount from your accounts, you will die with money in the bank. And this now-inherited IRA, for example, is taxed at your heirs’ rate. Under the new SECURE Act from December 2019, distributions from inherited IRAs to individuals other than spouses must be fully distributed in 10 years. There are some exceptions and other issues such as disabled individuals and minors, but that is the general gist.

The IRS wants to collect your previous IOU to them, like a Vegas bookie, and they don’t want to watch you keep kicking the can down the road.

So, for you there is tax savings built into the RMD system since not all the money is taken out and taxed. If you add in your heirs’ marginal tax rates, perhaps this changes from a “family unit” perspective. Heck, you’re the dead person- let your kids worry about your taxes by assuming them as their own. It takes a while to payback for all those sleepless nights and stinky diapers, but eventually it happens.

All kidding aside, here is something to consider- with life expectancy well into the 90s, your children might be retired too when you pass. Crazy but realistic, especially if you had kids before you had a career.