In Part 1, we discussed the Taxable Column and how taxes every year (or every time you realize a gain) can have a devastating effect on your long-term accumulation prospects, such as retirement planning. Because of this, the Tax-deferred Column gets a lot of attention. Let’s explore the pros and cons of this column, as well as the common vehicles we typically find therein.
The Tax-deferred Column
In this category, we have vehicles such as:
- Defined Contribution Plans
- Thrift Savings Plans (TSP)
- Keogh/HR 10
- Defined Benefit Plans
- Traditional IRA
- SIMPLE IRA
- SEP IRA
The first and major advantage to the Tax-deferred Column is that taxes are delayed or postponed (not nullified or canceled) until much later (presumably retirement) when you start taking income from these accounts. Any potential growth is, therefore, unhindered by taxes along the way.
Remember the example of a dollar doubling 20 times to become roughly $1,000,000 from part 1? Within a tax-deferred account, that could theoretically happen because no taxes would be assessed as the money grew within the account. Yes, taxes are still due when you use the money on the backside, but even if taxes were 50%, and you liquidated the account all at once, you’d be left with $500,000. This is a lot more than $72,000 from the example in part 1, right? That’s the power of tax-deferral.
2. Pre-tax Deposits
The second advantage to a 401k/IRA (or their siblings listed above), is that you are allowed, generally, to deposit money pre-tax. Everyone loves this, and the financial community at large lists this as a significant check in the plus column. Essentially, if you have $100,000 of taxable income and put $15,000 into a qualified plan, you now only owe taxes on $85,000 currently (you will be taxed on the $15,000 later). Do not make the mistake of believing this creates a tax “savings”; it is deferring or delaying taxes until later, when the hope is that you’ll be in a lower tax-bracket. We’ll address that in detail below; but for now, we’ll leave pre-tax deposits listed as an advantage.
3. Creditor Protection
In addition to growth potential and pre-tax savings, many of these types of accounts are creditor-proof, or at least significantly protected from creditors. So, in bankruptcy, lawsuits, etc., your assets might be protected from those incidents depending on the laws of your state.
Most of the accounts in the Tax-Deferred Column are what are called “qualified plans.” An important question is, “Qualified with or by whom?” The IRS, of course. There is a litany of strings attached to these plans/accounts that are important to understand. This section, detailing the disadvantages of this column, will be somewhat lengthy.
1. Age Restriction
The first drawback is an age restriction. In order to use your 401k/IRA without penalty, you must be 59 ½ years old. If you use the money before this age, save for a few exceptions, you will not only pay your ordinary income tax bracket on the money, you will also pay a federal 10% penalty tax. Some states add their own penalty on top of that (like California, adding a 2.5% penalty . . . thanks guys). So, someone in a 28% ordinary Income tax bracket, under S9 ½ years old, who needs to use his or her 401k money will easily pay 38%+ in order to access it.
All of a sudden that liquid emergency fund in the Taxable Column makes a lot of sense. With a generally limited menu of investment options inside qualified plans, any financial opportunities you wanted to take advantage of would likely have to come from a different source due to the age restrictions and illiquidity of a 401K or other work-sponsored plan.
2. Forced Usage
The second disadvantage is what is called a Required Minimum Distribution (RMD). This is another age restriction of a sort. In the year you turn 72 years old, you must take a minimum distribution from your 401K/IRA, even if you don’t need the money. The amount is based on your prior 12/31 account value and your age. This forces you to pay some tax on that money sitting there.
What? You didn’t think your investment partner (the IRS) was going to let you defer taxes forever, did you? This can have severe tax ramifications for you, potentially knocking you into a higher tax bracket, making your social security income taxable (or to a greater extent than it already is), even disqualifying you from certain social programs that are income based. What happens if you don’t take your RMD? A 50% penalty tax on the amount you should have taken, plus the taxes you normally would have owed.
Remember, strings are attached.
3. Nature of Taxes
Now we get more serious. The nature of taxes is the third disadvantage to qualified plans. Many times, instead of referring to 401Ks/lRAs as tax-deferred plans, we refer to them as “tax procrastination” programs. We all know what usually happens when you procrastinate something.
It gets worse.
The theory in 1979, when the 401K was coming into the limelight, was that if you deferred some of your income into the 401K now at your current tax bracket that you will be in a lower tax bracket in retirement, thus saving you some tax. For a simplified example, if you are in a 35% tax bracket and earned $10,000, you would owe $3,500 in tax. Instead, if you deferred that $10,000 into a qualified plan like a 401K, you would not pay taxes on that income currently. You defer (procrastinate) the taxes owed. Years later when you retire, assume you are in a 25% tax bracket, and then use that $10,000 from your 401K. You would then owe $2,500 in tax, instead of $3,500. You saved $1,000 in taxes. Sounds great, right?
That was the theory.
Now, four decades later, you might imagine we have some data on that theory. For the vast majority of retirees, this has simply been a bust.
Retiring to a lower net tax situation is by and large a myth.
In our many years of experience in working primarily with those who are near or in retirement, we have rarely witnessed our clients retiring to a lower tax environment. The industry, in recent years, has finally backed off of this once “sacred doctrine” of retirement planning.
Why? What happened? How were so many so wrong?
If we were to gather 100 of your family and friends, and ask each of them if they believed taxes will be lower, the same, or higher in the future, what would each of them likely say?
We have asked thousands of people this question. The answer is always the same.
Another way to ask the question is, “Will the government need more or less money in the future?”
For all the well-meaning advice surrounding this topic, the gurus touting pre-tax accounts, like 401Ks and IRAs, seem to have forgotten that taxes go up over time, not down. In qualified plans like 401Ks, lRAs, etc., what are you doing? Procrastinating taxes until the future, when we all rationally believe taxes will be higher. Scratching your head yet?
It doesn’t make sense. The old dogma of being in a lower tax bracket when you retire has fallen flat. Is it really smart retirement planning to procrastinate taxes until the future, knowing taxes, as a long-term trend, go up over time? This is highly similar to buying something on credit and letting interest build up against you over time. It will cost you more in the future. And, yes, the IRS does know what they’re doing here.
4. Loss of Tax-deductions
The fourth disadvantage of qualified plans is the loss of tax-deductions. Most Americans have three major tax deductions during the course of their careers: 1) pre-tax contributions to a qualified plan; 2) the mortgage interest deduction; and 3) kids (being a dependent deduction and child tax credit—2 for 1!).
We think you see where this is going.
When we retire, we’re not putting money pre-tax into a 401K or the like, we’re taking money out. That tax-deduction is gone.
If you have followed convention wisdom, the mortgage is paid off (or nearly), so that tax-deduction is gone (or very meager by the time retirement comes around).
Finally, by the time most of us retire, the kids are grown and gone (or, let’s be honest, grown). Even if they’re not moved out, they’re too old to deduct them now. We guess you could always have more kids . . .
What most people are left with in retirement is the standard deduction as the extent of their deductions. Even if you have less income in retirement, it is entirely possible that your actual tax liability (the amount of dollars you pay in taxes) stays the same or rises simply due to the loss of deductions. Combine the loss of deductions with the reality that taxes generally go up over time and you’ve got a potentially very nasty scenario on your hands thanks to so-called qualified plans.
5. Qualified Plans and Long-term Capital Gains Taxes vs. Short-term Capital Gains Taxes
The fifth disadvantage of 401Ks/IRAs and their siblings has to do with long-term capital gains taxes vs. short-term capital gains taxes.
Short-term capital gains apply to any holding or asset you sell for a gain that you have owned for a year or less (365 days or less). Essentially, you pay your ordinary income tax rate on those short-term gains. So, if you’re in a 30% combined federal and state tax bracket, that is the tax rate you would pay on those gains. (NOTE: there are rare exceptions to this, such as the 1256 exemption on managed futures or the flat tax on precious metal sales).
Long-term capital gains apply to any holding or asset you sell for a gain that you have owned for more than a year (366 days or more). The tax rate is only 15% federally on those gains for most people. We don’t know about you, but we’d trade our tax bracket for 15%. All. Day. Long.
So, to review, short-term capital gains taxes = bad. Long-term capital gains taxes = better. Keeping all that in mind, here’s the issue: How long do you hold your 401K/IRA?
Long time, right? More than a year?
So, when you retire and start taking income from your 401K (or other qualified plan), do you get the lower, preferential long-term capital gains tax rates?
You pay taxes on your 401K/IRA distributions as if everything were short-term gains despite having the account for years to decades. Why? Remember when we mentioned above that the industry believes pre-tax deposits are an advantage to the Tax-deferred Column?
There’s a penalty for accepting the IRS’ offer to deposit money on a pre-tax basis. You give up your right to have long-term capital gains tax rates apply to your money.
Ouch. Again, the IRS knows what they’re doing. They’re not new to this tax game.
Some might argue that you are deferring salary or wages into the 401K, which would normally be taxable at ordinary income tax rates (the same as short-term capital gains rates), so it makes sense that you pay ordinary income rates on the 401K money when you take income from it. If we accept that argument (it’s not totally unreasonable), what about the gains or growth of your money? Why shouldn’t that be taxed at the much lower long-term rates? If you put your money into a portfolio, and never sold, decades later you should be able to access any gains (at the least) on favorable long-term tax rates. Keeping track of basis and gains with today’s technology is extremely easy, even when transferring between custodians/brokerage houses.
But, nope. This is the pre-tax penalty. In exchange for being allowed to save for retirement on a pre-tax basis, you lose the lower long-term tax rate.
We’d bet no one ever explained that to you.
Another frustrating piece of this is that while ordinary income/short-term capital gains rates change frequently, making it sometimes difficult to plan effectively into the future, long-term capital gains rates rarely do. If you’re in a 22% or 32% (or higher) federal tax bracket, your long-term rate federally is simply 15% (20% at most). Wouldn’t it be so much simpler if you knew what your taxes would likely be on your qualified plans in retirement?
6. Qualified Plans and Provisional Income
Finally, the sixth disadvantage has to do with causing taxation on your social security income. There’s a nasty little thing called “provisional income,” and the amount you have will determine if none, 50%, or 85% of your social security income will be taxable at your highest marginal tax bracket.
Here’s the rub: social security income on its own is tax-free.
Whether or not it remains tax-free depends entirely on what types of vehicles you use for the rest of your retirement planning. All qualified plans (401Ks, 457s, 403bs, TSPs, IRAs, etc.) count as provisional income, and therefore can (and usually do) cause your social security income to become unnecessarily taxed. This need not be the case with proper planning. Add that to the tax liability of 401Ks/lRAs and their siblings.
For a deeper dive on provisional income and how to potentially get your social security income tax-free, visit your post called “How Much of My Social Security Will Be Taxed?”
Strings and more strings. After all, a 401K gets its name because of where it’s found in the Internal Revenue Code: Section 401, paragraph K. By whom are these plans “qualified?” The IRS.
They know what they are doing.
Is It All Bad?
Well, no. Often, there is a company match when you contribute to a 401K (but not IRAs, obviously, as those are individual retirement accounts). If the match is at least 50% of what you contribute, it generally makes sense to contribute up to the match (but not more than that; any amount you could save above the match might be better used in the tax-free column). If the match is less than 50%, it might not pan out with the math. If there is no match, well . . . you probably know the likely answer there. Even with a suitable match, great care should be had in deciding to contribute to a qualified, pre-tax plan.
The third column is the Tax-advantaged/Tax-free column. Like the first two columns, there are pros and cons there as well. Finding out your ideal balance between each of the tax columns can lead you to a much healthier retirement picture, contributing to multiple streams of tax-free retirement income. Read on to Part 3 of The Tax Columns: How Will Taxes Affect My Retirement.