I continually have conversations with clients about their perceptions of qualified plans. Some tell me they save on taxes, others say they avoid paying taxes or do not pay as much tax as a result of their contributions to a plan. Still others tell me that the company matches their contributions, so they put the maximum they can into their plan. I even hear from some that they are saving for their retirement and think that is a good way to do so. Basically, they follow the advice of someone in the payroll department or simply do what the crowd is doing!
It is probably a good time to share some simple facts about these investment plans and perhaps dispel some of the untruths! First, let me say that a qualified plan, in and of itself, is not bad. What is bad is the fact that so few who use qualified plans know how their money is treated in these programs. It is important then, to understand exactly what these plans do. In that way, you can make a more sound decision if they are right for you!
There are many rules for qualified plans. But we can set aside most of those rules and focus on a select few that will clearly help you decide if they are right for you. Let’s just mention that depending on the plan the contribution amounts are limited. The funds are not liquid, meaning that you cannot withdraw the money before age 59.5 without penalty. There are some exceptions to the rule. Your tax advisor can advise you about those. Suffice it to say you cannot get at the money easily if you should need it. At age 70.5, you must take distributions, whether you need the money or not. Those are some of the obvious things that most are aware of. From here I want to focus your attention on three things.
First and foremost, traditional qualified plans, whether a 401K, 403B, IRA, SEP, SIMPLE, etc., do two things. They defer the tax and the tax calculation. Better said, they postpone the tax and the tax calculation! Your contribution allows you to delay paying the tax until a time in the future! Since the tax calculation is also postponed until you draw the funds, it is possible that you could pay the tax at a higher rate than when you contributed the money!
You may be thinking that when I retire, I will be in a lower tax bracket, so I will pay less tax. That may be true, but are you planning to cut back on your lifestyle to insure that you will be in a lower bracket? I certainly do not want to lower the standard of living I have become used to; do you? And, because you may earn less in retirement, doesn’t mean you will pay fewer taxes. Look back at history. Since the inception of income taxes, they have varied significantly, especially after wars in which our country has been involved. We are experiencing a very weak economy and our current president that wants to raise taxes to pay for the wars, the national debt and the additional stimulus spending, authorized by Congress. Be honest with yourself. Are taxes going to go up or down?
If you put money into a plan while in a higher tax bracket and you ultimately take distributions (or withdraw the entire amount) at a lower tax bracket, you win. You postponed paying the tax at the higher bracket when you made the contribution and you paid at a lower rate when you withdrew it! If the tax rate is the same, there was no advantage and perhaps another investment or saving plan may have proved more beneficial. If the tax rate is higher, you lose! You will pay more tax than perhaps, you needed to! In this case, had you paid the tax at the time you contributed to your plan and deposited the funds into a different type of tax favored account, you would have paid less tax.
You must also keep in mind that you will probably not have the deductions you have now when you retire. For many, the house is paid for or they move to a smaller house and pay cash for it (another topic for another day!), the kids are gone and so are two of the biggest tax deductions most people have! Education credits are also gone. Another important fact to consider is inflation. Based on a modest 3% inflation rate, you will need two dollars thirty years from now to have the buying power of one dollar today!
So, what tax bracket will you be in at retirement? Even if you may be earning a little less money in retirement, when all factors are considered, you will probably be in a higher tax bracket or at least in the same bracket you were in before retirement. What deductions will you have? Clearly, fewer than you have now. And that assumes no changes to the tax code which is also highly unlikely.
Many believe if they put a dollar into a qualified plan, they have a dollar invested. Assuming a 30% tax bracket, you have $0.70 invested. Thirty cents belongs to the IRS! That is the tax you deferred. And, those thirty cents will now grow inside your account until you withdraw funds. At that time, the IRS will calculate the interest on their money and you will pay the tax at interest. Here is an example that considers a $1,000.00 annual contribution with a 30% tax bracket for both, the deferral and withdrawal periods, and a 5% rate of return for thirty years.
Account Balance $69,761
Your Share $48,833
Tax You Deferred $ 9,000
Amount You Owe IRS $20,928
Company match is also something that is often misunderstood. If you are receiving a company match, I urge you to contribute only enough to your plan to receive the maximum the company match offers. If you do that, the company’s contribution will most times, cover your tax liability. To wrap your mind around this, consider your contribution of one dollar and your company match of 50% or $0.50. You now have $1.50 in your account. If you are deferring at a 30% tax bracket, $0.45 belongs to the IRS. That $0.45 will be paid to the IRS at some point in the future at interest!
One last thing to consider is that mutual funds have historically underperformed the indexes. If you research the history of mutual funds, you will draw that conclusion on your own. So, I am not going to spend any time discussing that. The more important point is that mutual funds are traded on the markets and come with various levels of risk. The potential for loss of principal exists with every fund. And in most cases, we participate in these plans to save for retirement or for college planning. The operative word in the preceding sentence is save. When we save, it suggests that it is money we will eventually need. Can we afford to risk loss of principal with our savings in a very volatile market? Don’t be fooled by the thought of being able to time your withdrawals with market highs. Ask our retirees today how that is working for them! Just look at the losses in the markets since the highs in 2007!
At Integrated Financial Concepts, we insure that our clients understand important factors like those discussed here. We teach them the strategies they need to know in order to insure no loss of principal as well as contractually guaranteed growth of their funds, to minimize their taxes and have complete control of their finances at all times. If your money is not working for you 24/7, contact us for a free, no obligation consultation. Visit our company web page or contact me directly for more information.
Jim Dierking
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