We think you’re with us a far as to how things breakdown, so we’re going to continue this example in summary form, as we did in Part 2.
Example 3: John and Erin
- Time horizon until retirement: 12 years
- Annual amount to save: $30,000 pre-tax
- Vehicle: SEP IRA (retirement vehicle for self-employed people generally; same tax treatment as a 401K)
- Combined federal and state tax-bracket: 35%
- Assumed annual rate of return: 7.5%
- Annual $30,000 pre-tax deposit produces a “tax-savings” of $10,500 per year ($30,000 X 35% tax-bracket = $10,500)
- Over 12 years, total tax-savings is $126,000
- Retirement nest-egg grows to ~$600,000 at a 7.5% rate of return (after 12 years and a month)
- John and Erin’s combined Social security income projection at retirement: $32,000/yr
Unlike the previous two examples, let’s assume John and Erin are comfortable spending down their nest-egg over retirement (a more common scenario that just living off the interest). They plan for a 25-year retirement. Let’s also lower their expected rate of return from 7.5% to 6.75% to be a bit more conservative in retirement. We’re changing things a bit so you can see that the principles we’ve been discussing remain relatively constant. We’ll keep the tax-bracket at 35%, even though taxes usually go up over time. Simplicity for the sake of the example.
- SEP IRA nest-egg value: $600,000
- Retirement rate of return: 6.75%
- Retirement period: 25 years
- Gross annual retirement income from SEP IRA: $50,000 (rounding down)
- Taxes owed: $17,500 (35% tax-bracket)
- Net SEP IRA income: $37,500
- Gross social security income: $32,000 (85%of which is taxable thanks to the SEP IRA qualifying as Provisional Income)
- Net SSI: $22,480
- Total annual net-retirement income (SEP IRA and SSI): $54,980
- Total annual taxes owed (SEP and SSI): $27,020
- John and Erin’s annual tax-savings: $10,500
- Annual amount they repay the IRS: $27,020 (157% return in favor of the IRS)
- Total tax-savings over 12-year pre-retirement period: $126,000
- Total taxes paid over 25-year retirement: $675,500
- Number of years to pay pack all 12 years of tax-savings ($126,000): 4.6
- Additional taxes the IRS gained above tax-savings they provided: $549,500
After all this, you have to wonder why the plans like 401Ks, 403bs, SEP IRA, traditional lRAs, etc. are called "qualified plans." With whom do they qualify?
The IRS, of course.
We’re being a little cutesy here (qualified plans technically "qualify" under ERISA guidelines as retirement vehicles and are hence called "qualified," lest anyone should assume we don’t know that; the term "qualified plan" is loosely used to describe any pre-tax, tax-deferred vehicle by the industry at large even though that’s not technically correct), but we think you get it. Pre-tax vehicles are nice up front but can (and usually do) exact a terrible cost on the backside.
In the previous 3 examples, we were generous in our assumptions. For example, we did not assume that taxes went up. That’s kind of a crazy assumption. The numbers are even worse if we (rationally) did assume that. And if it is rational to assume that taxes will rise in the future (check out our national debt recently?), why are we enamored with savings taxes on the front end only to pay heaps more later?
Perhaps it’s because we are a fast-food society. Perhaps we are short-sighted. Perhaps the financial industry did a real number on the American public by beating the false idea into us that we will be in a lower tax-bracket in retirement—notice how that’s not really touted as heavily anymore? Yeah. It could be all these things and more, but we believe it’s more related to one thing:
Sometimes, we simply don’t know what we don’t know.
Read on to Part 4 for a little breath of fresh air using the example from Part 1 with Ryan and Jen and their retirement scenario.