A 401(k) offers tax deferral, not tax savings. The video breaks down how required minimum distributions work, compares tax-deferred versus tax-free accounts, and explains why government retirement plans often lack the control and flexibility people need.
Nearly everyone has heard of a 401k, and many people contribute to one every pay period. And though people contribute to these programs, what I have found is that they are very few people who really understand how they work. 403Bs, 457 plans, IRAs, they all fall into this category of government programs. And they're very common. Not because they are your best option necessarily, but because the government has made them so convenient. With these plans, contributions can be deducted from your paycheck, and there's no need to think about making the contribution. It's out of sight, out of mind. In addition, when these participants file their tax return, they don't have to pay current taxes on that portion of their income. Tax preparers love these programs because they can say they have helped lower your tax bill in the current year, making them feel like they're winning the tax game. This all sounds good on the surface, but there are a few problems with these government plans. Many people believe that they are avoiding tax when they contribute to a 401k, but the truth is that they're not. A tax deduction through deferral is not the same as a true tax savings. In other words, you either pay taxes now or you pay them later. A true tax savings is something that you can write off of your taxes to receive the deduction with no future liabilities. But with a 401k, you're simply deferring tax to a later date. That's a big difference. But let's look at the math of this and see if it's worth giving up control over your money. Let's say that you're putting $10,000 a year into your 401, getting to deduct the contribution and assuming a hypothetical 8% annual rate of return. If you take that 10,000 at the 8% return over 30 years, you'd have accumulated $1.2 million. Now, you probably wouldn't do this when you reach retirement, but I'm going to just assume that you're going to take that 1.2 million out of the plan and you're just going to cash it out and pay the taxes. That 10,000 that you put in was tax deductible. So you didn't pay any taxes on the money contributed or the growth. So 100% of the money subject to tax. Now, if you pull the 1.2 million out all at one time, you'd probably be in the highest tax bracket, but I'm just going to assume 25% again, just for illustrative purposes. So at 25%, you'd pay $305,000 in taxes, and that would net you around 917,000. Now let's take a look at using an account where you keep control over your money but do not receive that tax deduction up front. Instead of using a tax deferred account, you're using a tax free account. So you have $10,000 with a 25% tax liability up front netting you $7,500. Taking that $7,500 a year and contributing it into a tax free account for 30 years, at 8%, you would net the exact same amount of money, which is 917,000. So using the same rate of return, same gross numbers, you'll find that the results are the same. So since you really are not saving taxes on the contributions into a 401, what you'll find is that you're only deferring the tax liability to a point in the future when you have no idea what the tax rate will be. You see, these plans are not necessarily touted amongst peers because they're the best option. They are touted because people may think that they don't have any other options. They don't realize there are other programs available that give them more control, more flexibility, and less tax burden down the road. While there's no perfect investment, 401 s or other government programs require you to give up control of your money and hand it over to the government. You may think that you're simply saving money for retirement and getting a tax deduction for doing it. But there are two specific restrictions that wreak havoc on many retirement plans. First of all, you give up access to your money until you're 59 and a half. Distributions see are subject to an early withdrawal penalty of 10% on withdrawals prior to 59.5. And you have very limited access to the money while you remain employed. Even if you're okay with paying the penalty. It is only when you terminate employment that you can have access to your money without a hardship or taking a loan. Then you are forced to take your money at seventy and a half, whether you need it or not. The IRS enforces what they call a required minimum distribution or RMD in the year you turn seventy and a half. These two points are the source of many financial difficulties for people because the rules are dictated by our government and don't always coincide with what your needs are at any given time. I have clients who need money before they reach the eligibility age of 59 and a half, and I have clients who don't need the money that they have, but are forced to take the money at 70 and a half. Either way, the government is either restricting access or they're forcing distributions, neither of which may be what you need at the time. Another hidden myth within all this is that some people believe that there's a lower tax bracket when they retire. This is not true that the IRS does not offer a different tax code for retirees. You have the same tax brackets when you retire as you do now. The only difference is that we don't know what the rules are going to be in the future. And to add to the problem, when you retire you will likely not have the same amount of total tax deduction as you do now. Think about this for a minute. If you are contributing to a 401k, you no longer have that tax deduction. Since you have not been contributing and getting the tax deduction from your contributions, you do not have that amount to write off. Other deductions are child credits and deductions that may be reducing your tax liabilities today but will not be there later, such as home mortgage interest. So if you're deferring taxes into retirement, you have money coming out of these plans 100% taxable without these deductions to offset your tax liabilities. Ra.
