The Truth about Tax Deferment

Here’s a summary of our evaluation of the 401(k) and IRA so far.

(1) These investments are risky because they are a stock-market-driven approach

(2) The buy and hold strategy works great over an 80-plus-year period. BUT, most of you reading this probably have a 5–30-year investment window

(3) They are sold on a misleading “average return” that we’ll never actually benefit from.

That leads us to...what about the tax-deferred benefit?

Surely, that has a differentiating value enough for us to assume risk regardless of what our actual return ends up being, doesn’t it?

Do you think taxes will be higher or lower in the future?

I know how you answered because I’ve asked this question to thousands of people who have attended hundreds of financial workshops that I’ve conducted over the past 15 years. Everyone, and I mean everyone, answers that question the same way. Actually, everyone answers not only the same way but also in the same way. It goes like this. First, people in the audience sort of snort, chuckle, or flat-out laugh out loud. Then they say something along the lines of, “Of course they are going to be higher.” Everyone thinks taxes are going to be higher!

The 401(k) and IRA are financial vehicles that defer your taxes until a later time when you just agreed they would be higher. See where I’m headed with this?

LEARN MORE!

Taxes in our qualified plans aren’t avoided; they are deferred. This is not a revelation, of course, and we all know this to be fact, but I can tell you from experience that hardly anyone ever mentally factors in what the bite out of his or her retirement income is going to look like when he or she becomes responsible for paying those taxes. Don’t take my word for it, though; I would encourage you to seek out the 70-somethings in your life and ask them how they feel about the income tax that leaves their hands every time they draw on their qualified account. They’re not going to be smiling when they tell you the answer, and I promise you that if they are honest, they are going to come clean with you that they really hadn’t anticipated how much that tax bill would sting.

There is a cost to deferring your taxes; unfortunately, no one ever examines it in order for us to make a better decision over whether that cost is worth accepting. Let me explain.

Example: Young Woman in a 33% Tax Bracket

Let’s assume that a young woman in the 33% tax bracket began saving when she was 35 years old. She puts $4,000 away diligently into an IRA. So her total annual tax deferment will be about $1,320. Now to make it easy, we’ll do two things. First, we’ll give her an annual return on her investment of 10%. Yeah, I know. In the last post we spent time calling out the fact that the market will probably never give you year-over-year actual growth of 10%, but let’s just assume that this is what she’ll be earning. The second assumption we’ll make is that she’ll maintain the $4,000-a-year contribution for each of the next 30 years. So it looks like this.

Now let’s focus on the distribution of her IRA. Will she likely take a lump-sum distribution from her IRA? No. Where would she put it? Instead, she will likely withdraw the money over time. Let’s assume a 10% withdrawal each year, as she continues to earn 10% on the balance. Believe it or not, I’m trying to make this look as good as I can for her.

The bottom line here is that between the ages of 65 and 85, this woman will have paid over $450,000 in taxes for the right to have saved $39,600. Please explain the tax efficiency of this approach.

Now, one of the first arguments that people make when I run through this example goes something like this: “Yeah, but wait a minute—you’ve kept her in the same tax bracket. My accountant told me I will be in a lower tax bracket.”

When I get that question, and I always get that question, I look at my audience and I say the following: “If you are in a lower tax bracket when you retire, then it means you have FAILED FINANCIALLY!” Who the heck wants a financial plan designed to be in a lower tax bracket when you retire?

I don’t want to mince words. If you are in a lower tax bracket, it only means one of two things happened: it means you didn’t save enough money, or it means the money you saved hasn’t performed well—and you don’t want either scenario. Doesn’t it make sense to have a financial plan designed to be successful so that at retirement you are in a higher tax bracket as a result of your successful financial planning and investing? Of course it does. Putting a financial plan together assuming that you’ll be in a lower tax bracket is another way of you conceding that you are going to be a financial underachiever. Why would you want to be that person?

BOOK A CONSULTATION!

How about you put a plan together based on your being successful and as a result being in a higher tax bracket? That’s a plan based on success. That’s what I want. How about you?

The bottom line is this: if you are banking on taxes being lower when you retire, then you are in for a wake-up call.

So with that in mind, let’s go back to that perfect retirement that I had you think of earlier. Remember? House paid off, kids grown, big old qualified retirement accounts? Not looking so perfect now? Our income tax is going to hurt, and because our house is paid off and our kids are grown, the two biggest tax deductions we enjoyed our entire lives are gone when we need them most. And what did you get for this “perfect retirement”? Your money completely tied up and illiquid for 20 or 30 years.