If you have a qualified plan, what do you do with it?
Do you continue to fund it?
Is it the most efficient place for you to put your cash?
First of all, when you fund a qualified plan, you’re relinquishing control of cash and you’re putting it into a financial tool where you are choosing not to pay the tax on now, but you will pay it at a later date.
You’re taking pretax dollars, you’re saving them in an account where most of the time your cash is allocating in the stock market.
There may be some self-directed IRAs where you’re allocating in real estate or some other investment areas, but I bet over 90% of you, maybe even as high as 95%, from what I’ve seen, have money in qualified plans: 401(K)s, IRAs, SEPs, Simples where you’re relinquishing control of that cash and it’s in the stock market.
It’s in these variety of mutual funds and stocks where it’s allocated high risk equals high rate return type investments.
The majority of you have no idea if that’s a good thing or a bad thing.
It’s just what’s told to you from the HR department. It’s what you were told by your accountant or CPA as if they know-it-all on investment strategies and long term savings strategies.
They have knowledge around tax and accounting, but is that really a good thing? Let’s measure this. Let’s actually take and measure.
Number one, what I hear the most from you when you come into my office, we’re talking about your qualified plan. The number one thing that I hear is that there’s a tax savings.
Have you heard this before? Do you think this right now? Do you put money into a 401(k) or a Simple or IRA into a qualified plan? Those are all qualified plans. Do you put money into a qualified plan because you believe there’s an actual tax savings by doing so?
Let’s discover if there is.
Is there a tax savings to put money into an IRA?
What are the benefits of a qualified plan? We’ll take a simple number here. I’m going to be very general with this, but you can apply it in any way you want. We’re just going to show a $10,000 of income and we’re going to show a pretax and we’re going to show a post-tax.
If you do a pretax, you’ve got all 10 grand that’s going to go into the qualified plan. Let’s say you’re going to save it somewhere for 30 years, and that’s $10,000 a year that will go into the qualified plan, and you believe you’re going to average a rate of return of 5%.
Now, that’s a net 5% after management fees. Really ought to be around 3% or 4%. I’m going to let you have the five.
I know you think 9 or 10. That’s okay. In fact, for this discussion, let’s use an 8% annual rate of return. If you have 10 grand that you’re saving in a qualified plan, 10 grand a year going into the qualified plan earning 8% a year, what will that grow to?
You can do this with any future value calculator. You can go to calculator.net if you want to.
We’re going to take $10,000 a year annual payment at 8% earning rate for 30 years, that grows to $1,223,459.
30 years from today, investing $10,000 a year for 30 years at 8% a year will grow to 1.2 million.
Now, you have to pay tax out of that, so minus tax. We’re going to use a 30% tax. Whether you pay this tax from distributions yearly or you pay it as all one lump sum, what is the tax that will come out of that money?
If we just take a simple calculator and we take the 1.2 million. Then we’re going to times it by 0.3, so that’s going to be the number that we subtract from that, which is $367,037. That’s the tax that you pay.
If we take our calculator and we take that 367,000 of tax from the 1.2 million, it leaves us with 856,421. Do you see that?
Again, you may be saying to yourself, “Hey, I’m going to pay that out over time in distributions each year.” Okay, but you’re still going to pay whatever tax rate you’re in. We’re just going to cover this concept first, then we’ll go into taxes in just a moment. It nets $856,421.
I know you’re probably thinking, “I’ll be in a lower tax bracket in the future,” we’re going to address that.
Now, my other option is to take the 10 grand, pay my tax on it, and then save the difference.
If you take the $10,000, you pay the 30% tax on, that nets you $7,000. Now you have $7,000 after-tax that you could choose to save and invest somewhere. If you took that $7,000 a year for 30 years, and you made the same 8% rate of return on that money for 30 years? What do you think that number grows to?
Let’s take $7,000 at 8% for 30 years. It grows to $856,421. Wait a minute. That’s the same.
It’s the same number, $856,421. Whether it’s pretax or post-tax, if the rate of return is the same and the tax is the same!
If you’re at the same tax rate today that you’re going to be in the future, there’s no benefit. There’s no actual tax savings.
When you choose to put $10,000 pretax into a qualified plan, you have a partner with that 10 grand. That partner is called the IRS. In fact, they’re cheering you on.
They may even give incentives to businesses and corporations and bailouts because they want their cash to continue to grow.
In this example $7K of it is growing for you, $3k is growing for them, and they’re both growing.
How much tax did you pay in the pretax? $367,000.
How much do you pay in the post-tax? If you pay $3,000 a year for 30 years, that is $90,000.
You pay $90,000 to the IRS in post-tax or you pay $367,000 to the IRS in the pretax.
There’s no tax savings by doing a qualified plan, unless you’re in a lower tax bracket in the future.
We want you to pay your tax today, and then save it somewhere where you don’t have to worry about what the taxes will be in the future.
Lets take a look at tax history since the US Federal Tax since its inception in 1913 until today. Have you seen this? You can actually Google this and find this historical data on the web.
Imagine living in 1912, and they come knocking on our door and they said, “Next year your income is going to be taxed to the federal government in the form of an income tax.” It started at low rate of 1%, with a high rate of 6%.
From 1913 until today, the average is 57% for the high rate.
The 1913 high of 6% lasted for three years. Then the high rate jumped over 15%. Then skyrocketed over 60, over 70 and then it dipped back down during the great depression. Goes as low 24.5, and then it went up over 60, it went up over 70, it when up over 90%!
Did you know the highest bracket at one time has been as high as 94%? Can you imagine paying 94 cents out of each dollar, if you were in the highest bracket? Did you have any idea that it was that high?
Well, many of us have not lived through paying 70%, 80%, 90% in tax. Ronald Reagan did. He was making movies and he paid the 70% bracket. He helped it dip back down to 28.5.
Today we’re at 39% for the federal income tax.
This has nothing to do with state income tax, or property tax, or all the other taxes that we pay. This is federal income tax. Remember, we’ve averaged 57.9.
Today, we have the most amount of pressure being put on government-subsidized programs than ever before. The most amount of debt increasing at an alarming rate. What we do know is where we’re at today. We have our kids as dependents, we have our mortgage interest deduction, which are our two biggest personal deductions where we actually get a tax savings.
Right now, we’re choosing to make the decision of pre or post-tax dollars. We want you to pay your tax today, in most situations, and save your money after-tax somewhere where it won’t be taxed, or it’s tax-favored in the future. We don’t know what the tax rates are going to be in the future.
39% today, but we’ve averaged 57.9. We don’t know what it’s going to be in the future. How many different presidential elections are going to take place between now and then? What we do know is where we’re at today and that we are well below the average.
I hope I’m always in the highest bracket. That means I’ve got the most amount of money coming in from my wife and I. That we’re spending, that we’re enjoying, that we’re using, exchanging in the marketplace. We’re in the highest bracket today, I hope we’re always in the highest bracket. Do you get what I’m saying here?
The qualified plan myth is that there’s a tax savings. There’s not.
There’s not an actual tax savings in your pocket. It’s a deferral only.
Is the deferral a good thing or a bad thing?
I don’t think it’s a good thing. Not in most situations; sometimes it is.
But if the investment has to be allocated in the stock market, then you’re relinquishing control of cash and taking all that risk on it.