Is Your 401k Enough to Retire? (Hidden Taxes Explained)

Most people think saving money is the hard part. Getting the paycheck, setting something aside, and feeling good about their progress. The common advice has been simple. Just throw it all in your 401k, and you're going to be fine. But here's the problem. If all your money lives in one tax environment, you could be staring down a massive tax bill in retirement, one that wipes out far more than you ever expected.

At OmniStar Financial, we've spent more than 20 years helping successful families and business owners across 23 states build, protect, and transfer wealth with confidence. And today, we're going to show you exactly how to use tax environments to take control of your financial future.

Here's how we're going to walk through today's conversation. We'll look at three families, Elijah and Penelopey Taylor, Colt and Timber Browning, and Martin and Elise Aspen. Each of them is in a different stage of life, but they all face the same challenge. How their money is divided across taxable, tax deferred, and tax-free environments. And by the end of this episode, you'll know exactly where you fit and what steps you can take to have more control over your money and your taxes.

So, Phil, I'm going to set the stage for Elijah and Penelopey Taylor. I'm going to tell you a little bit about them and then we're going to go through some things that we think maybe they have right and then some areas where they might need to improve.

Okay.

So, Penelope and Elijah are married ages 34 and 36. They have two young kids, four and six years old. Their household income is about 220,000. They have 150,000 saved across 401ks, Roth IRAs, and a small brokerage account. They have a mortgage and they have some student loan debt, not insurmountable.

So, here's their situation. They've been saving diligently, but most of their money is piling up in tax deferred accounts. They want to buy a bigger home and save for kids college while still planning for retirement. If you're similar to the Taylors, you're likely saying things like, "Wait, so we've been saving like crazy, but every dollar in retirement is taxable at my ordinary income?" What do you say to that, Phil?

Yeah, I think everybody at some point they figure it out, but early very few times are you going to talk to someone who says, "Oh, yeah, I was told that." Right? Most of the time people don't know they're in partnership with the government.

Here's the real problem. If you don't embrace the tax environments and learn what they are early, Spell, you're going to get a huge surprise down the road. And when I say down the road, the further down that road you go, the less likely you will have time to fix these problems. So, we've got to talk about them now so that people can make better decisions. What are the positives you see here? And what are the things that we need to work on?

Well, I think the positive is this family, this couple, they're saving.

Mhm.

They've got basically they're getting close to one times their salary and they're what did you say? 34 and...

34 and 36.

So, they're almost right on the mark for what they should have at this point. I'd like to see them with closer to 200,000 saved by now. So, maybe one to three times their salary is really where they should be and a lot of expert opinions out there on that. Fidelity did a great piece on that and so I'm just referring to those types of mnemonics, but that's a good one to think about. So, I think that's positive.

The fact that their income is where it is, they're making pretty good money.

Yep.

They're thinking about the children's college. They got a lot of good things going on. So I think they want to do well and they're in the right direction. There's a lot of positives when I look at a young family that is at this level at 34 and 36 years old.

So, Phil, you seem to think that they're looking pretty good at this point, but what else do they need to be thinking about? If they had professional help, what would the professionals be nudging them to do?

Well, if they were working with us, I can tell you the first thing would be just getting them to feel comfortable understanding the tax environments.

Yeah.

Knowing where tax is going to happen, where it's not going to happen. How do we get them into those tax environments in the right way in the right amounts?

Phil, let me interrupt you real quick for the viewers who don't know. Can you explain what the tax environments are?

Well, yeah. Everybody lives within these environments and so the personal environment, the worst one, it's where most everything lands because people don't know there's other environments a lot of times, right? But everything that rolls through the personal environment, meaning your W2 income, any kind of earned income, it's usually going to flow there. And unless you direct it to another environment, then you're going to get hit with the highest level of tax.

Yeah.

So then we look at things like tax deferred environments. We look at things like tax advantaged environments, tax-free environment, obviously the best one if you know how to use it.

True.

And so you have tax preferred environments as well. And so there are great parts to all of those environments. If they're not used wisely, then most everything is going to land in the personal worst or it's going to land in tax deferred, i.e. 401k plan, which means when you hit retirement, all of that money coming out is going to be taxed as ordinary income like you earned it again.

Yeah.

And your tax deduction today is not nearly enough to offset the ordinary income tax that'll hit you when you start the distribution.

Yeah. Let's fast forward. They're 34 and 36 years old. Let's fast forward to retirement and let's say they've been able to accumulate a million dollar balance in a tax-deferred environment. That million dollars isn't really a million dollars, is it?

No, that million is really $700,000.

Yeah.

Best case, and that's assuming only 30% tax. Who knows where taxes are going, Spell. I know we have an administration in the White House today that says they want to bring taxes down, but that same administration admits that we have 36 37 trillion of debt and a $1.1 trillion annual deficit. So, I don't care who's in the White House.

Yeah.

I don't know how we pay for all of that without seeing taxes rise at least a little bit and maybe even just incrementally. But I think they will go up. I don't expect them to go down.

Yep.

So, I think 70% of that bucket of money at best is what you're going to keep, but it doesn't have to be that way. There are other ways to navigate this. And that's what tax environments are all about.

And they've got a great opportunity because they're young. So, if they get good help or great advice now, they can really make a difference long term for them.

Yeah. It can be huge because right now, and I don't want to make this sound like 150,000 of income is not a lot, but right now they're probably not at their peak income, their peak earnings, and so while it's at 150 and while they have those two children, which give them great tax benefit, and while they have these high standard deductions, so a lot of things working in their favor, all of a sudden that adjusted gross income can go way down, which means things like Roth conversions could be of great use to them. Or just pouring money into Roth instead of putting it all in traditional, let's start using some of the tax-free environment.

That's going to give them huge advantage because that money gets to compound just like the traditional side of their 401k. And what if they end up with a million in that side of the plan in 10 or 20 or 30 years?

Sure.

Then that's all tax-free to them and to their kids or anyone else they want to leave it to. That's really where to me, in our opinion anyway, I think I speak for our firm, that's really where the sizzle begins to happen because now you're really taking advantage of some of the environments that a lot of people just forego or they forget or they just don't know.

True. True. So, Phil, let's move on to another set of sample clients. Elijah and Penelope were in accumulation. That's the phase or stage that they're in. But Colt and Kimber Browning, they are in pre-retirement or their peak earning years. That's the stage of life that they're in. So they're married age 52 and 48.

Okay.

Their household income is 400,000.

Wow. They're doing good.

Yep. They've got a million8 saved. a,800,000 saved. That's mostly 401k. They have two kids. One is in college. One is in high school. 150,000 left on their mortgage.

So, here's the situation. They want to retire in about 10 years and dream of buying a lakehouse. That's their dream. But their heavy concentration in tax deferred accounts will mean large required minimum distributions or RMDs and potentially high tax bills in retirement.

So, we see clients like this all the time. And this is usually what they're saying. We've got nearly $2 million, but why does it feel like it's not enough? So, Phil, what do you say when somebody says that $2 million doesn't feel like enough?

Well, first, I'd agree with them.

Yep.

Because at 52 and 48, I'd like to see them with at least six times their household income, which means 2.4 million. If they've got 2 million, I'd say they're 400,000 behind, right? They're a little bit behind.

Yep.

And it could be a little worse than that. And it sounds like the lifestyle that they desire, what you're describing to me, it's going to require a lot of money. They're going to need a lot of money. You start buying second homes and upkeep to those second homes, managing all of that, that runs into a lot of money.

Yep.

And so I would first say to them that yes, you are behind before you start thinking about buying a lakehouse.

Yeah.

Let's be sure you're on track. And Spell, this is really where planning becomes so important. I don't want to call it critical, but in a lot of ways it is.

Yeah.

Because if you don't know that you're behind, then you're not likely to do anything. In fact, Spell, I don't want to digress, but I talked to a new client this morning. They're in another part of the state, so more toward the western part of North Carolina, and they said to me, it's been 10 years since they've done any financial planning. And I just thought you've been so busy working, and he's a CEO of a company or the president of a company, does well, but he's so busy. It's sort of that old saying, the cobbler goes without shoes. They're so busy working on everybody else's shoes they forget their own.

Yep.

And so he and his wife, they've done no planning, two kids, mid-40s, and they're doing well but they really have no bearing and there's nothing to compare, right? They don't really understand are they ahead or behind, where should they be and where should they be in the next 5 years or 10 years.

So I think in this case, and they're such a similar age to the ones you're sharing with me here, I think this really tends to illuminate the weakness of not having good tax diversification.

Yeah.

Because I might say if they have more of this in a tax-free bucket, I might say, you know what, they're a little behind on the 2 million, but because it's tax-free, we might be able to live with that.

Yep.

But if it's taxable, no way.

For sure.

Right. So I think this is not all bad. Look, they're doing some things right as well. The fact that they've got say four times or almost five times their household income, that's good.

Yeah, that's good. They're certainly on the right track.

Looks like they've got college planning built out. That looks good. Some good stuff here. But they still have some debt. They still have other things they've got to deal with.

Yeah, that's right. And one other thing that maybe it might be beneficial for you to talk about this for a viewer who doesn't know, but I mentioned that they're going to have pretty significant RMDs or required minimum distributions. What kind of a blind spot should we illuminate for them?

I think RMDs or required minimum distributions, they are so misunderstood.

Yeah.

We have clients routinely who say to us, "What is that?"

Yep.

And these are seasoned people, right? When I say seasoned, I mean they're mature. They're 50, 60 years old in some cases. The RMD can be such a shock when you reach that age when you're forced to take money.

And bottom line is you said a little while ago that anyone with qualified funds, all of that money doesn't belong to them.

That's right.

And we agree they're in partnership with the government because part of those funds are going to be taxed regardless.

That's right.

So if that's the case, the closer you get to retirement, that's going to... you have to start planning really differently for your spendable income. So you got to take out a lot more to live your life. And sometimes there's the other side of that coin where someone doesn't need the money yet the IRS is going to force them to pull it out. And that's because the IRS says, "Hey, we want to get paid some of the tax."

Right.

Now, the problem with all of that, Spell, is when they put all the money in, they did it pre-tax. Yeah. And they saved a little bit of money. And if they put $1,000 in and they were in a 30% tax bracket, they saved $300. Yep. Right. Yep.

When they start taking it out, let's say to your point, they've got that 2 million or three million sitting in that account and all of a sudden in their first year of required distributions, they have to take out 150,000. What's the tax on that? Yeah, for sure. Right. 30% tax rate if that's what they happen to fall into. That's $45,000 in one distribution and they only got a few hundred a year savings on their taxes going into it. Yeah. Over all those years.

My point is the distribution cost far exceeds the benefit, if you will, of getting that tax deduction when it's going, right? Huge difference. And that's a big blind spot if you don't plan for it. Could change your ability to maintain your desired lifestyle. 100%. In other words, you might have to settle for a lifestyle.

Roth conversions. In a show that we did together not long ago, there are a lot of different opinions that you can find on YouTube. A lot of them. Some people preach Roth conversions as the only thing that anybody should ever think about. There are other minds who say that it should never be thought about. And then there are some people that are in the middle. But those are the ones that really don't know. And in fact, I think none of them know. Yeah. They just want to share what they believe is their expertise.

And right, I do believe there's a time for Roth conversion. Yeah. And I believe there's a time that you should avoid it. True. And I think at the end of the day there's just discussion that needs to occur. That's right. And in analysis, the right analysis needs to be done to figure out where and when it makes sense. Yeah. Or before you get to the point of having to convert something to Roth, how about just diversify across the tax environments from the get-go?

I would say to anyone out there who's wondering, is your situation being improved because you're taking advantage of the tax environments, or is your situation getting worse and you don't know it because you're not aware of the tax environments? It's true. If we do nothing but implore people to ask questions, then I think we've done our job. Yeah.

We'll get right back to today's show, but first, I'd like to ask you a quick favor. If you're enjoying this episode, hit that like button and make sure that you're subscribed to our channel so you don't miss what's coming next. And hey, if something in today's episode has you wondering about your own financial plan, why not get a second opinion? Visit omnirestarfinancial.com to schedule a consultation with one of our team members. It's quick, it's easy, it could make a huge difference in your financial future. Now, let's get back to the show.

We're going to talk about Martin and Elise Aston now. And so, I'm going to get them on the screen. And so we've gone from a young group to a middle-aged couple. So, I'm guessing you're throwing some more senior-like people at me now. Some more senior-like people. And we're going to have to talk to the person who put together these images for us today because Martin and Elise are 67 and 62. This is not an estate planning issue. This looks like they're about to die. They look like they've seen some better days. No offense to Martin and Elise, but good grief. I'm sure they're fine people.

Spell. They had, Phil. They had stressful jobs. That's what it was. They had really stressful jobs. Their kids ran them ragged. No, I'm kidding. I'm kidding. Probably the grandkids, too. Well, they have five grandkids. Okay.

So, they have three grown kids. They have five grandkids. They're living on $200,000 worth of withdrawals. So, they're pulling from an investment portfolio now. Okay. They have social security, so they've got that piece as well. They've got three and a half million saved across 401k, IRA, Roth IRA, and a taxable environment brokerage account. They're debt-free.

So, here's a little bit more about their situation, what they're trying to achieve. So, they're in retirement. They're enjoying life, but they're worried about future RMDs. By the looks of it, they should already have RMDs. No wonder they got so many wrinkles. Exactly. Worried. Y uh so they're worried about future RMDs and how taxes will affect their ability to gift to kids and grandkids. Remember, they've got five grandkids, three grown children; across the three kids, five grandkids. They're also worried about health care costs, and estate planning is also a major concern of theirs.

So, these clients are saying, and we've heard this too from clients at our firm, we've worked hard to save three and a half million. It's taken us a lifetime to do it. How do we make sure it lasts and blesses our family? Such a great problem to have. For sure. So many people don't get to this stage. It's true. And when they do, there's nothing more disappointing than seeing a lot of that hard-earned wealth be eroded by things like taxes. Yeah.

So, in this case, first, congratulations to these two because they're living the American dream, if you will, which is not owning a home, by the way. That's not the American dream. But the American dream is the pursuit of happiness, right? That's part of it. And these people have it. So they have five grandkids. That is awesome and so good for them.

But they have some issues there. They're talking about gifting. Well, everything they gift because everything is locked into, I think you said their three half million dollars is sitting in 401ks, IAS, that kind of thing. Mhm. Every dollar that they take out is going to be taxable, which means that the cost of each gift is significantly more. That's right. So I see that as a real issue.

And so, in this case, having the right tax environment, structuring that, right, as you said, doing it long before you reach this age is the best play. But if you're already there, then what can we do, right, to mitigate some of that tax or reduce that burden? And I don't think it's so much here about just having the money. It's structuring the withdrawals so the money lasts more and helps them accomplish the things they want to do.

So could be using things like donor advised funds, QCDs or qualified charitable distributions or donations. Those things become really powerful, for sure. So just, and that's just a few of them, but those things along with other types of gifting can, the gifting to their kids is not going to create a tax for the kids, but it is going to create a distribution tax for them when they start pulling it out of the IRA. That's right. So, how can we offset that? Knowing how to coordinate all of those things can help this couple, Martin and Elise, they can have a lot more success than they know. Yeah. If they're getting the right advice.

There's so many tools out there, Spell. And I think that's part of the challenge, by the way. Our system has gotten so complicated. Wealth management 30 or 40 years ago was simpler because you didn't have all of these tax loopholes to the extent that you have them today. And you didn't have all the changes going on, nor did you have necessarily the amount of wealth that we see people today. That's true.

Planning today is just different. You better know the rules, you better know the tax laws, you better understand what lever to pull, when to pull it. Otherwise, I think you end up with a lot of degradation to the net worth. Yeah. And unnecessarily, really. Yeah. It's true.

I'd say the majority of our clients are probably at this age. They're asking us these questions and they rely on us to coordinate withdrawals. How do I fund my lifestyle in retirement? And Martin and Elise have done a good job. They have a little bit of diversification across the tax environments. They have some Roth money. They have some brokerage account money. So there's an opportunity there to reduce tax.

They're not at RMD age yet at 67 and 62, but preparing for that and knowing that Martin and Elise are charitably inclined and they give to their church and they give to other, maybe they give to 501c3 organizations. You mentioned qualified charitable distributions. Well, when one of them turns 70 and a half, that's a way for them to, one, they won't have an RMD quite yet, but they can move money from the IRA out of the IRA to the charity and it doesn't cause any tax.

That's right. That's, I think, where you made a great point. You have to have someone in your corner who's well-versed and knows all of the things that are, because if not, you're going to hurt yourself. Your money is not going to go as far as it could have gone.

Well, there's so much of that to think about today. Just like with the latest tax code changes with the one big beautiful bill that was passed recently, there's an extra $6,000 of tax deduction coming to seniors. Yep. So, if you're already into retirement, there's an extra six grand, assuming you don't make over a certain amount, but that's money that could be used to offset some of the taxes that they might be facing. For sure.

Just knowing these little things can allow you to do more planning regardless of what your situation looks like. So, doesn't matter if everything is boxed inside of a qualified plan that's going to create all this tax. There are still ways to minimize those taxes. And I think it's a travesty that so many people reach this point, Spell. Yeah. And they're not prepared for it. They're not planning. Their professionals aren't talking to one another. And all of a sudden, as we've talked about on other shows, they end up making a lot of distributions or a lot of tax mistakes. Yeah. That over time could be costing them hundreds of thousands of dollars, maybe more. That's true.

So, Phil, no matter where you are, you could be the young builder, the high earning family, the pre-retire, the retiree. It's all about balance. When we talk about tax environments, the goal is balance, right? We tend to refer to our elements in terms of making sure that things are well coordinated. Coordinated, and I think if things are coordinated, you have a much better chance.

But at the end of the day, Spell, the IRS needs money. They need money because our government overspends every year. Every year we spend two trillion more than we bring in. And we bring in, by the way, about $5 trillion in mostly tax receipts. Well, to say that the IRS needs more money, really, that to me is embarrassing, the fact that we spend that much more. But the point is they need the money, right? And they're happy for you to be in this situation because they know they're going to get money.

Doesn't have to be that way. But you have to learn, our listeners and everyone else, you have to learn how to spread your dollars, however many you have, across the tax environments in such a way that you get the greatest effect of good tax planning regardless of your goals and objectives. And so all those tax environments used properly can be built to match and blend with your goals. Yeah. If that's not done, then sorry, you had an opportunity. You chose to ignore it, and so you're probably going to spend a lot more than you had to.

If you enjoyed this episode, click or tap the screen now to watch a video that Phil and I did about why making more money could be making you broke.