What is more traditional that saving money inside a tax-deferred investment plan like a 401(k), 403(b), or IRA? This is the most common place for people to save for retirement. And yet, it is a horrible way to save money, and only compounds your tax obligation.
Did you know that a person with $400,000 in a qualified retirement plan (taxes have been deferred) will never receive more than 30 cents on the dollar? That’s because when you retire and take income from a 401(k), that with very little withdrawing this money forces your Social Security benefits to be included for income tax purposes. This can drain off $5,000 or more in tax payments. This is new — meaning it has not always been the case until just a few years ago.
In the following real-life example a couple only received $120,000 of the $400,000 in their 401(k) and this was taxed at 25 percent. Plus it forced the Social Security benefits to be taxed and they lost $6,200 a year in this calculation. They lived 17 years past retirement age, so the taxes on just the Social Security equaled $105,400.
Here are the calculations for this example:
- $120,000 minus 25% tax = $30,000$
- Subtract $30,000 and net received = $90,000
- Subtract the tax on the Social Security benefits which would not have been taxed if it hadn’t been for the diligent savings into this “terrific” qualified tax-deferred retirement account of $105,400.
- Couple didn’t even get 5 cents on the dollar.
Take issue with me all you want. But as you do so, I ask you to do your own homework. Talk to any CPA who prepares tax returns for many clients. Ask them if this example is unusual. They will confirm what I have posted here. One of my accountant colleagues has told me that the most he has ever seen a client get out of a qualified plan is 30 cents on the dollar. He said
most retirees get much less than 30 cents.
Even though these returns sound bleak, let me remind you of decisions you have made about saving money into a tax-deferred account. First, you are the account manger. You make all the decisions. The problem is you only have 12 places to put the money. This is a big limiting factor. Second, you have market risk sitting all around you. Third, you have to pay taxes on any money you take out and if you take money out before age 59 and a half, you pay an additional 10 percent penalty for early withdrawal.
What do you do then to save for retirement and not compound your taxes? Stay tuned and I will post another blog with precise details. You will love the alternatives to a 401(k). It will not force Social Security benefits to be taxes and it allows you to control all the money over your lifetime and beyond using a living trust.