Saving Your Retirement

(Chapter 2)

I want to talk about qualified plans by examining how they work, what they do compared to other strategies, and how they mesh with some other opportunities in the financial planning process.

First, please understand that I am not against qualified plans; 401(k)s, defined benefit pensions plans, profit-sharing plans and IRAs are great vehicles. They are a good way to accumulate wealth and can definitely create a forced investment for employees as well as employers. Certainly, it gives them opportunity to create wealth. That said, let’s explore more in depth the philosophy of a qualified plan.

First, we take a portion of the money we currently have and put that into, say, a 401(k) plan, thereby reducing our taxable income. Each of those dollars is then going to grow with no tax whatsoever, and so the fund just continues to grow until retirement. At retirement, we have the opportunity to access that money for retirement income. However, at that point, it’s 100% taxable.

Nevertheless, the traditional wisdom is that you are taking a tax deduction today, so that it may grow tax deferred, letting that whole dollar go to work now, and upon retirement, you will be in a lower income tax bracket. That philosophy certainly made sense in 1980 when the first 401(k) was put in place and the top tax rate was 70%.

However, does it make sense today? Few believe that tax rates, or effective taxes, will go down in the future, especially when considering the growing national debt. Most everyone I talk with—CPAs, attorneys, investment advisors, financial planners and clients—concur that the effective tax rate likely will be higher in the future. The graph below shows the relationship between income tax rates and the national debt. For the national debt to go down, there will have to be an increase in income tax rates. If that is true, does it make sense to take a tax deduction now in what may be the lowest income tax bracket of our lifetime? Does it make sense to defer all that tax on both the principal and the interest until retirement, so that we can pay tax on both the principal and interest in the future at a higher income tax rate? Instead, would it not be more prudent to pay tax on those dollars today and never pay tax again on the principal or interest earned on that account?

Figure 2

Secondly, you need to look at this tax question from the perspective of retirement years. Leading up to retirement, when you are contributing to a pension plan, 401(k), or profit-sharing plan, you are enjoying a 100% tax deduction today. But remember, in retirement you do not have an income stream other than savings, pension accounts, and the other wealth you accumulated to continue living in the same manner you did during your working years. Not only do you have to pay taxes on the taxable retirement income, you may also lose deductions, such as mortgage interest, dependent deductions, or business expenses. Consequently, you will be paying taxes from what you have saved through the years at a potentially higher rate.

To illustrate, you may have built a $1 million retirement fund, but it is not worth $1 million because you will pay tax on that income stream when you are not working. In other words, you have to take it out of your savings.

On the other hand, by doing the math, if you pay taxes now, during your working lifetime when there is more cash flow, and if you do not have to pay tax on your retirement income stream, then 1) you will not have to accumulate as much money. For example, if you accumulated $1 million in a 401(k) and you took a distribution of 7% or $70,000—all of which is taxable—you would net $52,500 assuming a 25% tax rate. On the other hand, if the distribution were tax free, you would only have to accumulate $750,000 to net $52,500, assuming a 7% distribution. 2) If you do accumulate the same amount of money in the tax free account as you did on the other investment in a qualified plan, you will have a much richer retirement income because you do not pay any tax.

So, the question becomes, “Do I want to pay taxes during my working lifetime when I have income, lock in the current tax rate, and not be subject to future increases, or do I want to pay taxes out of my retirement savings and be subject to unknown, probably increasing tax rates, which means I will have to accumulate more wealth to meet my needs?”

Not only are all qualified plan distributions taxable, but as the next two chapters will explain, the underlying investment—and thus your retirement income stream—is exposed to market instability and sequence of return risk.