401(k)s & Taxes: What You Need To Know

The majority of us have been told saving for retirement starts with a 401(k). 401(k) is actually the section of the tax code that allows earners and employers to create an account that is not taxed at the time of earnings. The strategy is that money is taken directly from earnings, pre-tax, and put in an investment account in hopes of seeing growth through the working years. This allows a larger sum of money to be deposited because taxes are not taken out at time of earning.

The theory is that when you are then in retirement, you will be in a lower tax bracket than when you were working. This strategy has been touted as tax savings and in most cases it is correct. However, one thing that plays a factor in the success of the tax reduction, is the actual tax rates when one pulls that money out of those accounts.

Taxes For Individuals Are Going Up With The Expiration Of The Tax Cuts And Jobs Act

As of 2025, those tax cuts will have expired, meaning tax rates are going up. For many middle-class Americans, a bulk of their retirement savings are in tax-deferred accounts such as a 401(k) or IRA. These types of accounts mean that taxes have not yet been taken out. This money was set aside during the time of employment and as those accounts grew, so did the tax bill that will ultimately come with them.

When you take money out of a tax-deferred account, you are typically going to incur a tax. The withdrawal will count towards your income, and will be taxed at your income tax rate. This means that when tax rates rise in 2025, your tax bill for your 401(k) just got higher. Some estimate that middle-class Americans have on average 80% of their retirement saved in tax-deferred accounts.  

Tax focused financial planners are a bit like a heart surgeon in a room full of doctors. While brokers and agents in the financial space all deal in items that may affect your tax-bill, not all are focused on those implications. It may be beneficial to seek a fiduciary that focuses on tax planning to learn strategies on how to avoid the potential of overpaying taxes. Timing of withdrawals, Social Security Income, and Required Minimum Distributions (RMDs) can all potentially have an effect on how much you owe in taxes each year.  

The Question Then Is, How Much Are Taxes Going To Rise In The Future?

Though it certainly feels like taxes are high today, and that feeling is made even worse with current inflation. In reality, if you look at the history of taxation in the nation, we are at some of the lowest tax rates we have ever seen. Many speculate with the national debt being at an all time high and the national debt rating being downgraded, that taxes will have to rise significantly. While our current highest tax bracket tops at 37%, in the past we have seen it as high as 94%, the average over the history of taxes in the US is 58.6%. So in discussing the possibility of rising taxes these are numbers that we have seen in the past that some speculate are coming back around.

But Haven’t We Always Been Told Taxes Will Be Lower In Retirement? 

This theory, which led to the popularity of tax-deferred retirement accounts is actually pretty simple, but is NOT based on tax rates but instead based on which bracket you may fall in. The idea is that during your working years your overall income from employers will put you in a high tax bracket. Once retired, you no longer have income from an employer so the tax bracket you will be in may be lower than when you were working. This has led pre-retirees to build up nearly $40 trillion in tax-deferred accounts.  As the government looks for ways to get itself out of debt, it may look towards these accounts to cash in. Tax-deferred by definition means that tax is owed on these funds. It’s been said that looking at the balance of your 401(k) you have to realize that this total doesn’t account for your silent partner who is waiting for their cut, Uncle Sam.

With recent changes to laws around retirement and taxation, there have been adjustments to increasing eligibility around 401(k)s making it easier for people to add funds, age requirements for RMDs, and now with the expiration of the TCJA, tax rates. In other terms, the government has changed the rules around when you have to take that money out as well as how much you will owe in taxes. It stands a reasonable connection that they continue to change these rules to help offset the mounting national debt.

When tax rates increase after 2025, your 401(k) or tax-deferred account is worth less than it would be at today’s tax rates. If tax rates head towards our all time high of 94%, or even just the nation's average top tax rate of 58.6%, your retirement savings could take an unplanned hit.

Speculation and percentages aside, when tax rates go up the tax-man owns more of your tax-deferred accounts, plain and simple.

Understanding the new tax implications of the current system can be difficult. Even some of the most experienced financial advisors can struggle if they are not versed in tax planning. There are firms such as Oxford Advisory Group, with founder Sam Dixon, who have made it a point to focus on tax planning when it comes to retirement.

One thing to keep in mind when planning for retirement, often the strategies you used when you were funding accounts need to change when you move into retirement and start living off those accounts.  A new series has launched that addresses some of the most common questions on how to do that called Retirement Wisdom.  These short youtube videos answer some of the most common questions in retirement. You can watch these HERE

Oxford Wealth Group, LLC is a federally registered investment adviser under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply a certain level of skill or training. The communications of an adviser provide you with information about which you determine to hire or retain an adviser. Information about Oxford can be found by visiting the SEC site www.adviserinfo.sec.gov. and searching by our firm name.

This is prepared for informational purposes only. It does not address specific investment objectives, or the financial situation and the particular needs of any person who may receive this report. The information herein was obtained from various sources. Oxford Advisory Group does not guarantee the accuracy or completeness of information provided by third parties. The information in this report is given as of the date indicated and believed to be reliable. Oxford Advisory Group assumes no obligation to update this information, or to advise on further developments relating to it.