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401(k) Savers: Who Makes Money (You or the IRS)?

Author: Montgomery Taylor
January, 2013 Issue

What if everything you believed about saving up a retirement fund was actually wrong? Your company offers you a retirement program and encourages you to take advantage of it. All the other employees are doing it, so it must be right—right? What else would you do anyway?
There are alternatives. I bet you’ll be surprised. You’ll be relieved to know that there are plenty of other investors swimming upstream, being contrarians and bettering themselves for it.

The history of retirement funding—in brief

From the mid-1980s to the present, many employers shifted the retirement plan responsibility to their employees by using a variety of supplemental retirement programs enacted by Congress. Currently, fewer than 30 percent of American companies still have defined benefit pension plans. The responsibility of funding retirement has slowly been shifting and placed on the backs of private sector workers like you.
So, now that it’s on your back, should you go with the flow and max out these government designed and regulated retirement savings accounts? This is a very good question to think about—don’t assume it’s the right thing to do.

The retirement plan trap

Let’s explore the dangers that lie below the surface. If Sandra were to contribute only $200 per month into a 401(k) over a 30-year period, she’d have contributed $72,000. If we project an 8 percent growth rate into the future, that $72,000 would have grown into a whopping $298,072—a 314 percent total return!
Let’s calculate the current tax delay (not savings) for Sandra’s $72,000 contribution, using a 20 percent net tax rate. Twenty percent of $72,000 is a total tax deferral (not savings) of $14,400 during all the accumulation years.
Well now, that’s not bad. We’d all like to save $14,400. But let’s not forget, that tax was never saved; it was just delayed.
For simplicity, let’s be generous and assume the same low net tax rate of only 20 percent in retirement. If we apply that rate to the total balance of the 401(k), you get a whopping tax liability of $59,614. Ouch! That doesn’t sound very appealing. So much for the benefits of the $14,400 tax deferral. That deferral just cost Sandy over four times more in actual taxes to be paid over the life of withdrawals from her 401(k).
The reality, however, is that the net tax rate in retirement will often be higher than the net tax during the accumulation years, due to the loss of some key tax write-offs. Realistically, Sandra’s combined net tax rate could easily be 30 percent to 40 percent. If the net tax rate was 30 percent, then the total tax liability would be $89,422. At 40 percent, the tax liability jumps to $119,229.
Would any of us really trade $59,614, $89,422 or $119,229 for a delay of paying a small $14,400? Of course not! But, unfortunately, that’s what millions of Americans are doing every day as they contribute to their 401(k). Just think how big these numbers would be if the example were based on savings of $24,000 per year—what many save for retirement.
What people fail to realize is that tax-qualified plans don’t avoid tax, they simply delay tax. And by delaying tax, these plans compound tax, making the tax burden worse—much, much worse. Think about it like this: If you were to be taxed on your garden in some way, and you had a choice, would you rather pay tax on the seed or on the harvest?
Is there a better way to go? I tell people to pay the IRS its $7,200 per year (assuming, now in this example, that you’re in a combined 30 percent federal and state tax bracket) while they’re saving the $24,000 annually for 30 years, and not take the government bait…I mean benefit. This way, your loss compared to the other scenarios is lessened. Why does this make sense?
Well, in our example, you have $24,000 to save per year. With my strategy, you gave $7,200 to the IRS, and now you have $16,800 to save for retirement. It’s wiser to keep that $16,800 out of your 401(k), and instead put $16,800 annually into a structured life insurance contract. Under current IRS rules, that contract will act like a high-octane Roth account without the IRS’ age and income restrictions as to accessibility before age 59. The advantage is that the buildup of your savings is tax-free, meaning that if your savings brings in 5 percent returns this year, this 5 percent will not be taxed.
Another advantage is that withdrawing your money from the life insurance cash account for pre-retirement emergencies or needs can also be tax-free using loans under current tax law. If you die prior to your planned retirement age, there’s a tax-free death benefit for your loved ones that will be considerably more than the after-tax amount of your 401(k).
The math also shows that the life insurance contract would provide 30 percent more monthly income than the traditional qualified plan due to the tax-free loan provisions of the policy—30 percent more income plus an enhanced death benefit that qualified plans don’t give you.
You were surprised by the tax problem building up in your retirement accounts, weren’t you? Don’t feel alone. Most people never give this issue due consideration. But as you can see, without bucking the system here, we’re saving for Uncle Sam’s retirement as much as our own. This is one more piece of the financial planning puzzle and points out the importance of integrated planning. When you combine the strategies in the legal, tax, investment and insurance areas, you’re on your way to peace of mind.
Montgomery Taylor is the author of Before It’s Too Late, a recently published book about retirement and estate solutions, especially for baby boomers. This article is a brief excerpt from Chapter 4. You can purchase the book at Mr. Taylor is an investment manager and CPA with 30+ years of experience. You can learn more about his work at or by calling (707) 576-8700.


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