There are primarily two things you should expect in a qualified plan (aka QP):
- First of all, they defer the payment of taxes (but they do not necessarily save taxes).
- Secondly, they defer the tax calculation.
Let me illustrate how QP’s actually work: If you came to me looking to borrow money and I gave you a check for $10,000 what are the two things you most likely need to understand?
- When do I have to pay it back?
- How much interest are you going to charge me?
If I told you I don’t need the money now, but there will come a time in the future when I do, and at that point in time I calculate how much I need and what interest you will have to pay me, are you going to cash that check? No way! But that is exactly what the government is doing with qualified plans.
There is value in putting money in a qualified plan up to the match, but not a penny more. Most people think that by retirement age, they will be in a lower tax bracket. My response: do you really want to reduce your standard of living or do you just want to pay the least amount of taxes? They tell me the choice two but when they retire but this isn’t always the case. If you are in a lower bracket, then you will be better served by deferring the taxes.
Many wealth advisors and financial planners (and me as well) believe tax rates are going up, or the decision makers in Congress will lower the top thresholds, resulting in the government being able to collect more money. Based on this, I do not believe you can realistically expect to be a lower tax bracket.
We are concluding a war which we still have to pay for, there is all the debt the government has accumulated, and once retired, the odds that you will have many deductions is very low, because you are closer to achieving the “American Dream”.
Over their lifetime people drove to work every day, in cars that were most likely financed and replaced every 3-5 years, while they overfunded their retirement plans at work so they could get a tax deduction, and attempted to make money so they might accelerate paying off their house as quickly as possible, (take a breath here) with the hope that then they can really start saving for retirement. In doing this they received a deduction (QP) only to lose a deduction (home mortgage). QP’s have many such inefficiencies.
Whose dream were they chasing?
Will you be chasing your dream… or Uncle Sam’s? Here is a good example:
- Annual contribution to 401K/or IRA= $6,000 x 35 years=$210,000 total contribution
- Assuming a 33.3% combined tax bracket
- Tax savings: $6,000x33.3%=$2,000 x 35years=$70,000 total savings
- 35 years later account balance earning 7.5% for 35yrs grew to $1,000,000and they are only going to withdraw the interest.
|$ 75,000||Retirement Income|
|$ 25,000||Annual Tax|
|$ 50,000||Net Spendable Income|
|$ 70,000||Tax Savings for 35yrs|
|$ 75,000||Taxes in 1st 3 Retirement Years|
|$ 500,000||Total Tax By Year 20|
In this example, the person “saved” $70,000 in taxes only pay $500,000 in a 20 year retirement.
There is some good news
You have choices, and there are alternatives to qualified plans to save money, vehicles that also let you enjoy tax free treatment. If you are interested in learning more, perhaps we should meet to discuss your options. If not consider meeting with a qualified financial advisor who is familiar with the concept of avoiding unnecessary wealth transfers.