Since the fully funded company pension plan is fast becoming a thing of the past, the popularity of the 401(k), the IRA, the SEP and other 'qualified' retirement plans has skyrocketed. And why shouldn't it? After all you get to sock away large portions of your income on a pre-tax basis and then your money will grow tax-deferred for as long as you leave it there. But then what?
On the surface this seems like a great idea and so over the past 20 years or so hard working employees and business owners alike have plunked down BILLIONS of dollars into these government 'qualified' retirement plans. Yet, in my work assisting people to prepare for and enjoy retirement, I find that many people do not understand the risks, rewards, or the workings of their retirement plan! Yes, BILLIONS have been poured into these plans that the average consumer does not really understand!
For example, one of the most talked about benefits of a retirement plan is that you get so many great tax benefits. After all you get a tax break on your contributions, and your money grows tax-deferred for years until you finally need it at retirement. But then what? What about when you go to take out your money in retirement, don't you have to pay taxes then? YES! And you will most likely pay dearly!
But rest assured says the government (who want desperately for you to fund your own retirement since social security is in such turmoil) and your plan administrator (who is associated with a mutual fund company who desperately wants you to buy their funds)?'You will be in a lower tax bracket when you retire than when employed'.
While this may have been true at one time and for people in certain income brackets, today for many of us this is a big MYTH!
With the 1986 Tax Reform Act and subsequent tax reform, most retirees in America will find themselves in a tax bracket at least as high-if not higher'than during their earning years. Why?
Prior to 1986 when people retired they were entitled to double exemptions. This retirement tax break no longer exists. In addition to this most of the deductions that were helping them all those years are now gone. Think about it, they have a free and clear home so they no longer have the mortgage interest expense deduction. Not to mention their children have matured into adults so they can no longer claim them. With all of your tax deductions gone do you really think you will be in a much lower tax bracket?
In fact, US News and World Report published an article in by Leo Weidner entitled, 'How Congress Is Peddling IRA and 401(k) Snake Oil.' Mr. Weidner had this to say, 'One of the original IRA and 401(k) tenets held that deferring tax until retirement was advantageous because funds would likely be taxed at a lower rate. That is no longer axiomatic. You may well spend retirement in the same or higher bracket if you accumulate a respectable retirement nest egg. In fact, tax rates will likely rise in the future to cover budget deficits.'
The point is that you may end up paying even more tax dollars out in retirement than you saved over your working years. Does this mean all qualified retirement plans are evil? No. But it does mean there is a lot to consider when you are deciding where to save for retirement. For example, have you considered using other non-qualified tax advantaged investments that could give you tax-free retirement income instead of taking the tax break now?
To put this another way would you rather pay taxes on a small amount of money now or a large amount of money latter? I don't know about you but I would rather forgo the small tax break now and look for tax-free alternatives than save a little now only to pay a lot later. Ask your advisor about how you can not only defer taxes, but eliminate them on your hard earned retirement savings.
Advisor is a Registered Financial Consultant and a member in good standing of both the National Ethics Bureau and the International Association of Registered Financial Consultants.