Before you begin reading, I want to let you know that I am going to be completely discrediting traditional financial planning tools like the IRA and 401(k). This article will discuss why the IRA and 401(k), are the most inefficient financial vehicles in today’s economy. Although it is not something I do often enjoy, it is a great way to get excited.
Who should read this article?
This is an essential read for anyone who is still working and wants to save money for retirement. Imagine yourself in a traffic jam for 10 miles on the highway. My job is to show the way to get around the financial gridlock. Even if you have retired and are not contributing to a 401k or IRA, I urge you to continue reading. You will most likely think, “Yeah! He is right-on!” This is what I should have known 30 years ago. The following paragraphs will be of benefit to the retired person.
Let me ask you to think about your ideal retirement. For a few moments, think about what your financial situation would look like in that time period of your life. If you’re like most people, your vision of retirement financially involves living in a home you have paid off many years ago and one that has plenty of memories of raising your children.
You’re getting money from your retirement plan, getting some Social Security and enjoying the lifestyle you’ve always wanted (travelling when you want, visiting grandchildren often, exploring places you never thought possible). What if I said that the road you’re currently on, the one you chose to take to reach your retirement, was being backed up by an unforeseen problem? Would you like to find out immediately if that was true? You would.
Let me tell you that I have bad news. The most popular retirement plan in America is a backup route to your vacation destination. You need to change your course to address the problem. It is time to look at an alternative route so that you can achieve the perfect retirement that we just mentioned.
But first, how did 401(k), come into existence?
Before we get into the reasons why 401 (k) isn’t the best option, let’s first understand how 401 (k) was created. The first is that the 401(k), while it was intended to be the main source of savings and financing, was not meant to do so. An entire industry has developed to take advantage of a section in the IRS code intended for something entirely different since the early 1980s.
Section 401(k), part of the Internal Revenue Code, was created to compromise the federal government’s desire not to tax high-income earners and the desire of high-income earners to reduce their income tax rate. Employers could reduce profits by using the original language of this code to lower their tax burden. Ted Benna, a consultant in employee benefits, saw that the code could give employees a similar benefit. For his employer, Ted Benna petitioned IRS to amend section 401 to allow for the creation of such funds. The 1981 code was changed and seven million people were enrolled in 401(k). According to the Investment Company Institute and Federal Reserve Board, there were over $4.4 trillion (yes with a t), tied up in 401k plans as of 2014.
Why won’t 401k and IRA work anymore?
Let’s first look at the problems with IRA and 401(k). Then, let’s examine why they don’t work today.
The decline of pension funds
We are here 40 years after the inception of the 401 (k). For the average American, the landscape has changed dramatically. Nearly 80% of laborers had a pension plan in their compensation package in the late 1970s and early 1980s. The 401(k), in addition, was an ADDITION to the long-term financial plan that had been in place for almost everyone since World War II. It is crucial to read that sentence again. The 401(k), which was added to the long-term savings wisdom at the time, was not intended to replace it. The 401(k), while it can help you save taxes, was not intended to be your primary source of financing later in life.
Social Security Insolvency
Now, fast forward to the third decade in the new millennium. It is a completely different environment. Many political leaders think that Social Security will go bankrupt in the 2030s if there is not enough done to fix the current infrastructure. Today, less than 10% of employees have any type of pension plan upon which they can rely. The 401(k), which was once the third leg of a retirement savings strategy stool, is now the only one.
Are Taxes Set for an Increase?
Many employers have abandoned pension plans, and Social Security is at serious risk of going bankrupt after 10 years. There are several other issues that our country faces today that are very expensive to fix or maintain. Our national debt, skyrocketing healthcare costs and our global military footprint are just some of the issues that spring to mind.
There are many other examples. You don’t need an economics degree to understand that the government will require more revenue to address many of these issues or fund current programs. An increase in taxes is the logical solution to this need for additional revenue. Despite the fact that income taxes are now at an all-time low in this country, even though they were created by the IRS in 1913, it is not something you may have realized.
What’s the point? You probably chuckled at me when I asked if taxes were rising and nodded your head. The 401(k), and IRA allow you to defer taxes until a later date, when they will be higher. This is where you’re going with this.
Qualified plans don’t avoid taxes, they just defer them. From personal experience, I can say that very few people ever consider how the tax bite will affect their retirement income when they are responsible for paying them. You don’t have to believe me. I encourage you to ask the 70-somethings in the family how they feel about the income taxes that they pay every time they withdraw from their qualified accounts. You won’t find them smiling when you ask. If they are sincere, I guarantee that they will tell you the truth. They didn’t know how painful that tax bill would be. There are costs to deferring taxes. Unfortunately, no one examines them in order to help us make better decisions about whether it is worth the cost.
Your Average 401(k), and IRA – A Real life Example
Let’s say that a 35-year-old woman in the 33% tax bracket started saving at age 35. She saves $4,000 every year and puts it into an IRA. Her total annual tax deduction will be approximately $1,320. To make it simple, we will do two things. We’ll first give her a 10% annual return on her investment. Yes, we have spent a lot of time pointing out that the market won’t give you a 10% year-over-year growth, but let us assume that she will be earning this amount. We will also assume that she will continue to contribute $4,000 per year for the next 30 years. It looks this way.
- Annual savings: $4,000
- Durable: 30 Years
- Tax bracket: 33%
- Annual taxes deferred: $1,320
- Total savings at 10%: $723 744
- Total taxes deferred: $39,600
Let’s now focus on her IRA distribution. Is it likely that she will receive a lump-sum payment from her IRA. That is impossible. Because where would she place it? She will most likely withdraw the money gradually. Let’s say she withdraws 10% each year and continues to earn 10%. This is what I am trying to do for her.
- Annual withdrawal: $72,000
- 33% tax bracket
- Annual taxes paid: $23,760
- Net income: $48,240
This means that this woman will have to pay over $450,000 in taxes between 65 and 85 for the privilege of having saved $39,600. Please explain how tax efficient this approach is.
The Truth Uncovered
One of the arguments people make when I show this example is “Yeah but, wait a second–you’ve kept them in the same tax bracket.” My accountant said I would be in a lower bracket. We’ll get to this later. When I get this question, which I often get, I look at my audience and say the following: If you are in a lower bracket when you retire it means that you have FAILED FINANCIALLY!”
A financial plan that allows you to retire in a lower tax bracket is what everyone wants. I won’t mince words. You are either in a lower tax bracket or you didn’t save enough money. And you don’t want that to happen.
Isn’t it logical to have a financial plan that is designed to make you more tax-efficient? It does. You can also create a financial plan, even if you assume you will be in a lower tax bracket. This is another way to admit that you are a financial underachiever. What makes you want to be like that person? What if you had a plan that was based on your success and a higher tax bracket as a result? This plan is based on success. This is what I want. What about you?
As you’ll see, the goal should be to figure out how to handle taxes that result from successful investing. Let’s be clear: If you expect lower taxes when you retire, you need to wake up. Let’s now think about the perfect retirement I suggested earlier. Remember? Remember?
It is going to be hard for us to pay income tax. Our house is now paid off, and our children are grown. This means that the biggest tax deductions that we have enjoyed throughout our lives are no longer available when we most need them. What did you do to get this “perfect retirement?” You have had your money in liquid and locked up for over 20 years. You can’t deny it! This is quite brutal. This is a terrible example of fraud.