Ok, finally the sexy stuff….401(k), IRA, asset allocation, etc. All the stuff you have a ton of information on…but little to no education. Here is where I have a huge problem with today’s society and one of the key reasons I am writing this book.
I’m putting this image back up again. See down there towards the end of the row?? That’s where retirement goes! It’s one of the last dominoes to fall. However, you would be dumbfounded at the number of people I meet that completely blow off the first 15 chapters of this book in their personal & financial lives. They go straight to retirement!
Part of the problem is society & the greed that entails. The “drug of the stock market”. The “drug of tax deferral”. The “drug of employer matching.” The “fallacy of retiring in a lower tax bracket”. All three highly addictive.
Another part of the problem is my generation, the baby boomers. Telling their kids to “start early & fund it to the max…that’s what I would have done if I had a plan like this when I was your age!” Yeah, right…
I’ve got clients that are age 30 and have $100,000 in their retirement accounts. It’s impressive, I must admit. Then they tell me their dream is to open their own business in the next 3-5 years. See the disconnect? Their retirement account is for retirement…not for opening a business in their mid-30s. Try going to a bank to get a loan. You cannot collateralize an IRA in any way, shape, or form.
We have a rule at our firm on younger people and how they manage their retirement plan contributions. Until we can get you fully protected against today’s life changing events, and we can have you become World Class Savers in the appropriate buckets, retirement should be the last thing on their minds.
If we must meet in the middle on this topic, as the drug of employer matching coupled with the sexiness of investing in the stock markets do overtake our client’s logic occasionally. We offer the following advice:
MAX THE MATCH…BUT NO MORE!
Some companies don’t match at all. Some match on a percentage basis. Some match on “years of service” schedule. Keep in mind, this is a “Qualified Plan Asset” …Qualified meaning it’s qualified in the eyes of the US Government.
When you hear anything with a 3-digit number, such as 401(k), 403(b), 457, etc. those are sections of the IRS Tax Code that define these plans. An IRA is a 408 plan, just in case you were wondering. Qualified means they make the rules…they control how much you can contribute…and more importantly, how the money is treated upon distribution. Answer this question: “If you were a farmer, would you want to pay tax on the seed…or the harvest?”
If you said the seed, that’s the right answer, and you just defined why the ROTH 401(k) and the ROTH IRA are the best options for you. Not all companies offer the ROTH option, but most do today. Unfortunately, some of Nashville’s largest companies do not offer a ROTH option, and I scratch my head on that every day.
Here’s the difference between the two contribution types:
20% tax bracket, $5000 contribution. 30-year period, 6% average rate of return. Future value of that one year’s contribution = $28,717.00
You contribute and deduct $5000 from your taxable income that year. Total tax savings = $1000.00. In retirement, you’re in the same 20% bracket and you withdraw that exact amount in a given year. $28717.00 x 20% = Total taxes paid = $5743.40
Same $5000 contribution, but you pay the taxes on that dollar amount ($5000 x 20% = $1000.00 taxes paid). Zero tax savings in that year. In retirement, same 20% tax bracket, same dollar amount withdrawn. $28717.00. Withdrawal is tax-free. Total taxes paid $1000.00
See how “the drug of tax deferral” works against you? What happens if income tax brackets rise and you’re in a 40% tax bracket at retirement. The TRADITIONAL contribution pays the increased tax. The ROTH contribution is still 100% income tax free.
In case you are still not convinced, do the math…multiple times. In case you are addicted to the fallacy offered by the “financial entertainers” that you will retire in a lower tax bracket, let’s look at two separate but important facts:
On the previous page is a history of the US Federal Income Tax Brackets. These are the highest “marginal” brackets. Let’s look at history.
- World War I = 75% highest bracket.
- Great Depression – 25%
- World War II = 94%
- Reagan era = 28%
- Today = 39.6%
Let’s say you have funded your 401(k) plan from the Reagan Era to today. In the lowest consistent tax brackets in our history. What happens to your strategy of long term tax deferral if the income brackets go back to where they were in the 60s-70s? How’s that working for you now? It’s called “REVERSE TAX PLANNING”.
How much better would you and your family be if all those contributions for all those years were ROTH contributions and 100% of your distributions were INCOME TAX FREE?
Next point: The fallacy of retiring in a lower tax bracket. Even if you can withdraw the same amount of income from your retirement plans and the income brackets never change. How does that work? Today you’re in a 20% tax bracket. However, you also have deductions that reduce your taxable income and keep you in that bracket. Guess what? There’s a good possibility that you might not have these in retirement, such as:
- Tax deductible mortgage interest
- Tax deductible retirement plan contributions
- Deduction of having children at home
When you’re retired are you going to have a mortgage…or better yet, maybe it’s so small you can’t itemize anymore. Now you’re taking $$$ out of your retirement plans…and hopefully, the kids are grown and gone! By default, even if tax brackets never, ever change, you will be in a higher bracket in retirement.
Am I saying that funding retirement accounts is a bad thing? NOT! What I am saying is that since it’s one of the last dominoes to fall in your financial life, prioritize it that way. If you’re 50 years old, and your college funding plans are complete, your short and intermediate term accounts are plentiful, and you see clear skies ahead towards your retirement, maybe you can now fund them to the max…If you are maintaining World Class Savings of 15-20%, or even higher…your financial plan is working for you.
Some additional thoughts to complete this chapter. Hopefully by now, you can see the advantages and pitfalls of funding retirement accounts. One key item I see all too often are people that change jobs and fail to take their 401(k) with them.
Your contribution dollars are 100% vested immediately. Your employer may have a vesting schedule where percentages of their contributions are available depending when you leave their employment. Typically, after 6 years in most plans, their contributions are 100% vested.
You have two options: Roll these dollars into an IRA, or transfer them into your new company’s 401(k) plan. Both are acceptable, but don’t leave them sitting there! Once again, here is where the advice and counsel of a competent financial advisor makes really great sense!