By Nicholas Hamner
Investment Advisor Representative
[email protected]
“The most powerful force in the universe is compound interest,” is a quote usually attributed to physicist Albert Einstein. Did he really say that? Nobody knows. But what we do know is that if you start with some money in an account with any sort of rate of return, and you leave it alone for a couple of years, when you come back after those few years have passed, you’ll have more money than you started with. Such is the power of compounded returns.
This one concept is the foundation of long-term investing. We know that on a long enough timeframe, markets tend to go up. And we know that the S&P 500 averaged a net positive over the last 20 years. Long-term investing says take your money, park it somewhere, don’t touch it, and let compounding returns do their magic. But this same money-producing magic can also create a tax bomb that can really test your patriotic sensibilities. Here’s what happens.
Let’s say you’re 50 years old and you have $1 million saved in an IRA. You’re living off your existing income, not dipping into your savings. You’re doing good! Now let’s say that IRA money is in an index ETF and the market follows the same pattern it did from 2000 to 2025. Lots of up years, couple of flat years, and more than a few down years. Along the way, you reach 67, retire, file for Social Security, and you think about pulling some money from the IRA but… you’re used to saving, you can float it for now, so you leave it. Let it keep growing.
Here’s the rub. When you hit 75, whether you need to or not, you have to start taking Required Minimum Distributions (RMDs) on that IRA. Thanks to solid returns and you leaving it alone, that $1 million you had when you were 50 is now—25 years later—almost $5 million. Your first RMD is going to be north of $160,000 with something like $33,000 going right to the IRS. You have created an incredibly healthy savings, but it is a tax bomb and the tax hits are only going to get worse! Assuming the market patterns we hypothetically established earlier continue—mostly up years, some flat, and some down—in the first 10 years of taking RMDs, you will have paid Uncle Sam a half a million dollars and you’ll likely give him back more than a million before you pass on.
Yes, you will have spent your retirement as a multi-millionaire, but do you love the government so much you want to give them more than a million back? Probably not. I have never met a person who, upon finding $20 in a jacket pocket, excitedly yells, “Let me send Uncle Sam some of this!” And I know guys with American flag flip-flops.
Oh, and what happens to that IRA once you die? It’s going to someone. Probably family and loved ones. And thanks to the Secure Act 2.0, if anyone besides your spouse is the beneficiary, they have exactly 10 years to withdraw that money and pay taxes on it. And how many family members do you have with the money required to pay income tax on $5 million?
This tax bomb is messy and creates other tax bombs. And it definitely takes some of the fun away from being a multi-millionaire. So how do you diffuse it?
If you’re 72 and asking this question, there’s not a whole lot you can do that makes financial sense for you. But you can at least create a legacy structure to give the beneficiaries some tax-free money to help with the taxes on the distributions. If you’re younger, there are ways to limit the tax bomb’s impact by taking the hit early when it won’t be as strong. If you have ever discussed Roth conversions and wondered why anybody would pay that much in taxes up front… this is why. And finally, if you’re really young, you can avoid the tax bomb altogether by getting your footing on tax-free accounts like Roths and learning how to maximize their usage.
We can help with all of this, by the way.
I’m not telling you this expecting you to go out and do it on your own. In fact, for this column to pass legal muster I have to encourage you to remember that this is one big hypothetical meant for educational purposes only, that you should consult with a professional before doing anything discussed here, and that my mentioning it does not, in fact, count as a consultation. But—that out of the way—no one here at Franklin Retirement Solutions wants to see you pay any more tax than you absolutely have to. And we’re here to help. So if you’re staring down the lit fuse of your own tax bomb and want some help with it, give us a call.