Obviously many of us invest in some type of qualified plan (aka government-sponsored retirement vehicle), hoping that our money will be waiting there for us (nicely compounded) when we are ready to retire. But all too often, this isn't the case. With the massive numbers of baby boomers retiring each day, the problem is only going to get worse. What happens when we suffer another market crash, and the majority of thousands of people's retirement savings are virtually wiped out - right when they are about to retire?
We all love the idea of a "tax-deferred" plan - if we can defer paying taxes until some later date, why not? We tend to think of it in the short-term as "saving" money on our tax bill - even though it's actually deferred - not saved. Of course with our human desire for instant gratification, this sounds like a great idea! I don't have to pay taxes on my retirement savings until I retire? Sweet!! Well, the government is wise to our tendencies of procrastination, and don't think they haven't thought this through! Setting up these qualified plans was very strategic - and the strategy wasn't necessarily designed to favor YOU....
Let me show you what I mean. Let's start with a very basic example, and I will make a few assumptions to make this easier to calculate.
2. We will also assume a constant rate of return, which is virtually impossible for a qualified plan that is invested in the stock market, but as of course it is impossible to predict the performance of the market (ahem!), we've got to start somewhere.
3. We will also assume a level withdrawal of 5% in income from your retirement plan each year for 25 years following retirement.
Plan # 1: Qualified - Tax-Deferred:
Let's assume that our friend Joe is a diligent saver, and he is thoughtfully planning ahead for his retirement years, even though he is only 35. He plans to retire at Age 65, so every year for 30 years, he saves $10,000 into his 401k. He's in a 30% tax bracket, but of course he doesn't have to pay taxes on his contributions just yet.... Let's ASSUME that his 401k returns a steady 6% every year, so that by the time he retires, his $300,000 of contributions have grown to a cool $820,000 (approximate - based on compound interest calculator located here). Awesome! Now Joe has not paid taxes yet on any of the $300,000 he contributed.... (But wait! Now he gets to pay taxes on $820,000 instead??? Yep!)
Okay so let's calculate this out: If Joe withdraws 5% ($41,000) in income from his plan every year, he will pay 30% in taxes, and end up with $28,700 in income. By Age 90, he will have taken $717,500 in income after taxes. Uncle Sam will have also certainly gotten his share - $307,500 to be exact.
But that sort of sounds okay, right? Well, let's look at an alternative scenario. Let's say instead, you put your retirement funds into a non-tax-qualified plan. This means, you're going to pay your regular income taxes on the money you contribute now, but when you take the money out for retirement, you're free and clear, and don't need to pay any more taxes.
Plan #2: Non-Qualified - Taxed Now
Let's assume our other friend, John, follows this method instead. John is also 35 years old, and in a 30% tax bracket. He also wishes to save until Age 65 when he will retire. However, he would rather pay his taxes now, and not have to worry about it later - especially as he thinks it's entirely possible he will be in a higher tax bracket 30 years from now than he is now. So he pays his taxes on his $10k of earnings that he contributes to his plan, ending up with $7,000 going into the plan each year. John also earns 6% interest on his retirement savings, and at Age 65, he retires and starts taking income.
As he contributed less in total, his savings have only grown to approximately $575,000 - but remember he doesn't have to pay taxes on the money when he takes it out. John also takes $28,700 out of his plan every year for 25 years, and just like Joe, at Age 90, he has also taken $717,500 in income from his retirement plan. But Uncle Sam is not nearly as happy, since this time he only got.... $90,000.
Wait a minute! By participating in a tax-deferred retirement plan (which is supposed to be a great benefit to you), versus a non-tax-deferred plan, YOU came out exactly the same! But guess who came out WAY ahead?? (Ummm... surprise, surprise, the people who came up with the tax-deferred plan?)
Basically all this hoopla about "saving" on your taxes, finding all the ways you can to defer paying taxes until retirement, etc. really doesn't benefit you at all in the end! Not to mention all the things you have to give up by locking your money away in one of these plans for 30 years - i.e. liquidity, safety, penalty-free access, the freedom to invest in what you like, etc.
Obviously qualified retirement plans are now considered the "norm," but while the majority of people are relying on these types of plans for income during their retirement years, it's time to take a step back, and ask should we really be following the herd, or is there a better alternative out there? Isn't it time to take back control of your wealth, and do what's best for YOU with your retirement funds?
Here are a few helpful resources you might want to check out - they are all about taking control of your own finances and growing your wealth safely:
1. Someone mentioned that I did not talk about the issue of compounding, and the fact that Joe (with the larger balance at retirement) would have more money to compound while he is taking withdrawals, so he would end up with more left over (or could take more out). This is true. In fact, John (or even Joe for that matter) may run through his balance before 25 years have passed. I intentionally did not discuss this for simplicity's sake, as the illustration was regarding taxes - not the issue of spending down the retirement accounts. Yes, of course Joe would have more left over, or be able to withdraw for more years. Regardless, he is still going to pay WAY more in taxes than John in the end, even if they take out the same amount of income, which brings us back to the question, who is really benefiting more from a qualified plan - YOU, or the government?
2. What about capital gains? Meaning, since John's balance is non-qualified money, he will have to pay capital gains taxes on the the growth in his account, even though he has already paid income taxes on it. Again, for simplicity's sake, I did not get into this topic, and I am not a tax-professional, so you would want to consult one for possible ramifications when deciding how to set up your retirement accounts.
However, another reason I did not discuss this is that, if you properly use the vehicle and concept discussed in the resources mentioned above for your retirement planning (as I do), you would not have to pay capital gains taxes on your retirement income from this source anyway. :-)
I hope that clears up any confusion! If you have further questions feel free to comment below, or contact us on Facebook.