INCOVENIENT TRUTHS

DEFERRING TAXES

We have been taught by our grandparent, parents, relatives and friends that deferring taxes in our retirement accounts is a good thing, they said that you would have more money in the account so it would grow faster.  We have been told by financial professional and the media that when we retire we will be in a lower tax bracket.  What if what we have been taught all of our lives from these people that are supposed to know better is wrong?

First lets look at the statement that when we retire we will be in a lower tax bracket.  Really, is that your goal?  If you are in a lower tax bracket that means that you are not bringing in as much income.  When you retire do you want to live on less money than you’re living on right now?  Maybe the person that told you this thought that you would still have many tax write-offs.  Hopefully, the kids are grown and you no longer have that write-off, your house might be paid off and you no longer have that write off, and you are not saving for retirement so you no longer have that write-off.  That means you will be paying taxes on every dollar you take out of your tax deferred retirement account.  Now here is the BIG one, do you actually anticipate taxes going down in the future?

Now lets look at the idea that if you have more money in the account it will grow faster and you will net out more money if you defer your taxes until later.

If you have $100,000 in a tax deferred account growing @7.2% over 10 years will equal approximately $200,000.  If you are in a 25% tax bracket and take all of your money at once, you will pay Uncle Sam $50,000 and you get to keep $150,000.

Now if you have $100,000 and pay the 25% tax up front, Uncle Sam gets $25,000 and you keep $75,000 to invest in a tax free account.  Let’s assume the $75,000 grows @ 7.2% for 10 years just like the example above.  You will net out the same $150,000.

The truth to the equation is that you are really only creating more tax revenue for Uncle Sam and not more income for your self.  This illustration also assumes that tax rates will not go up sometime in the next 10 years, which we all know is not very likely.

401K’s

The 401(k) plan--named for a section of the Internal Revenue Code--came about thanks to a 1978 congressional provision intended to offer taxpayers breaks on deferred income.  The program was originally designed for executives, but the employers soon interpreted the legislation for their own benefit.  The employer knew that all they had to pay for is the administration costs of the 401k program and any matching that they choose to contribute to the employee.  This would in return save the employer and the shareholders millions a year.

The benefit to the employee is that they were able to save money for retirement and not have to pay income tax on the contributions put into the deferred comp plan.  This is really not a benefit and I will illustrate that in the next paragraph.  The other problem with this program is that it dumped the retirement planning responsibility on people that where never trained or educated on this.  That is why I refer to a 401K as an “ennie meenie minie moe” 401K.  Most people have no idea what mutual funds to pick, what percentages to put in each and how much money to put away each paycheck.  So what do they do….they play “ennie meenie minie moe”, and that is not a recommended way to save for retirement.

Now let me show you how getting a tax break now and deferring your taxes until later works.  First let’s assume that taxes will never go up or down throughout your lifetime and you are in a 25% tax bracket.  Let’s also assume that you receive a 7.5% rate of return on you investment every year.  If you are 30 years old and would like to retire when you are 65 – 35 years from now – and you put away $6,000 a year, in 35 years that would equal $210,000 that you saved.  Since you are in a 25% tax bracket that means that every year you save $1,500 in taxes and over 35 years you saved $52,500.  If that money compounded at our 7.5% over those 35 years you would end up with about $1,000,000 when you are ready to retire and start taking income.  Let’s assume that the money is still growing at 7.5% and you only want to take the growth from the account every year, which means you would have an income stream of $75,000 a year.  But wait, you have to pay income tax on that money now that you are taking it out. If you are in a 25% tax bracket you will have to pay Uncle Sam $18,750 in taxes and you get to keep,$56,250.  Well that might not be bad in retirement along with some social security and some other savings, but this is where you should be concerned.  If you live for 20 years in retirement you would pay $375,000 in taxes versus to $52,500 you saved during your 35 years of accumulation.  I wonder whose retirement you are really planning for, yours, or Uncle Sams.

The only way to use a 401(K) properly is to fund it up to the employer match and keep it in low-risk accounts.  If you are getting a 50% match that’s better than what the market does, I suggest that you just keep that and don’t risk it.

Market Loss

Many people experienced market loss in 2008, and the sad thing is that they didn’t need to.  It is amazing that so many people believe that they have to put their money at risk in order to get a large return.  To many people are risking their retirement accounts on the hopes of the 20% return in the market only to see fortunes disappear in a terrifying real-life game of high stakes gambling.  We unfortunately have been taught through greed, advertising and peer pressure that the only way to make a fortune is to be in the stock market, which few actually understand.

The primary objective for the intelligent investor should be to preserve principle and build on it with compounding interest at a moderate rate in both a bull and a bear market.  If you have your principle at risk, you are not investing you are gambling.

As Warren Buffet has said “You don’t have to make it back the same way you lost it.”

Let’s take a quick look at who actually wins when the stock market goes up.

The pyramid ranks the parties that are involved in the order of their potential for stock market returns. On top of the pyramid is the party that takes on the least amount of financial risk but receives the highest potential rewards.  The average investor takes on the majority of the risk but receives the lowest amount of returns.

If you find these inconvenient truths to be inconvenient to your retirement plan than you need to contact Coastline Financial Solutions so we can make your plan a lot more convenient for you.