The Tax Deferral Trap
I lost my 95 year old father September 21st of this year. He was a great guy, a great father to his kids and sharp business man too. He was always concerned about protecting his businesses cash resources, especially when it came to paying taxes. He worked very hard and wasn’t about to pay one dollar more than he had to.
As we began the process of estate tax planning the question of tax deferral came up for a couple annuity products that he graciously left behind for the kids.
As you consider what I’m about to explain, keep in mind that no one solution is right for each individual or family. But generally speaking you’ll see that the “benefit” of tax deferral is essentially a myth and will likely cost you more in taxes over your lifetime.
Let’s take a look at the so called benefit:
One benefit of tax-deferred investments is that they often occur during working years when earnings and taxes are most often higher than earnings and taxes during retirement.
Considering earnings..that could be true for some. After all, when we no longer have a working income it’s logical to assume our income will be lower. And “If” income taxes remained the same or were lower during retirement, you’d pay less income tax. Butt that’s A BIG “IF”!!
Many of you have saved for retirement in tax deferred Qualified Plans. Some may have a pension. You might be counting on Social Security as a cash flow resource.
As you withdraw from your tax deferred savings or pension plan, the money will be taxed as income. Hopefully at the same rate or lower than when you deferred the tax.
But there are other tax consequences of tax deferral to consider: If married filing jointly, and you declare $44,000 or more in taxable income, (think 401K, IRA or Pension) 85% of your social security benefit will be subject to income tax. Then there’s your medicare premiums to consider. Essentially another tax that will increase as your taxable income increases. Seems to me that deferring our taxes to later has us set up to pay more income taxes over our lifetime than is necessary…..at a time we can least afford it.
And what if the marginal income tax rates increase during retirement? A good possibility given the spending habits of our federal government.
Did you know the top marginal income tax rate has been as high as 94%? Over the last 100 years the top marginal rate has averaged closer to 60% than the current 37% rate.
So why are we pouring money into these qualified plans at a time when the marginal income tax rates are at historically low levels?
Example: Let’s use a combined Fed/State/Local income tax rate of 25%. Let’s assume taxes remain the same from the day you deferred throughout the withdraw period. Contribution to both plans (one Qualified 401K, one non-qualified Roth) is $100,000. Both plans grow at 7.2% per year over 20 years. Using the rule of 72, the money in both accounts will double every 10 years…assuming no losses to make this point.
|401K Plan||Roth 401K|
|Contributions||$100,000 (Tax Deferred||$75,000 (after 25% tax)|
|Pre-Tax Acct. Balance in year 20||$400,000||$300,000|
|Less tax owed @ 25%||$100,000||$0.00|
So where is the benefit?
The 401K account pre-tax balance looks good until you realize that it’s not all yours!
In fact, you’ll be 5th in line when it comes time to get your money.
First in line is the Federal government…next are the state & local governments, next your Social Security tax man gets his, then Medicare’s share is taken and finally you’ll get what’s left.
The only possible benefit to Tax Deferral occurs if taxes are lower during the withdraw period. Again, A BIG IF!
An individual who took advantage of today’s low marginal rates, effectively placing their money in a 0% tax bracket, has also minimized future taxes on social security and reduced medicare premiums. All things considered, continued increases in government spending, the historically low marginal tax rates of today and the associated income taxes placed on social security and medicare premiums, ….Tax Deferral appears to be more of a Tax Trap than a long term benefit.
When you & your CPA addressed the future impact of taxes on your 401K, Social Security and Medicare
premiums, how much did you figure the government will take and what kind of an impact did it have on
your your retirement lifestyle?
To your retirement success,
Dave Watkins - Saving & Retirement Planning Specialist
Helping America Protect and Grow Their Retirement Savings