The Real Deal About Retirement Savings
Maxing out your retirement maxes out taxes.
Most advisors recommend their clients put as much money as possible into their 401(k)s, profit-sharing plans, and other tax-deferred investment vehicles. On the surface it seems like a good deal, legally setting aside money for later use before the IRS taxes it.
While it’s true these plans can absorb hundreds of thousands of tax-deferred annual contributions, they are not so much tax deductions as they are discounts on the cost of saving money. Tax-deferred investments don’t save you any taxes. Remember, they’re “deferred,” i.e., put off until later.
Here’s an example.
Bill and James each make $1 million annually, putting them in a 40 percent tax bracket.
Let’s say Bill puts $100,000 into his retirement plan, where it won’t be taxed. His remaining $900,000 will be taxed at 40 percent, and he’ll take home the remaining $540,000.
James doesn’t put any money at all into his retirement contribution, so his entire $1 million will be taxed at 40 percent. He’ll pay more in taxes, but he’ll also take home more money at the end of the day that is not subject to the restructuring of a retirement plan.
The problem with maxing out your contributions to tax-qualified retirement vehicles comes way down the road, especially if you’ve amassed substantial wealth along the way. The problem is this: You are going to pay tax on tax-deferred investments. Yes, with the 401(k), a client may save some money at a discounted rate, but that money is totally inaccessible until retirement, and the client will ultimately owe taxes on it—income tax and potentially estate tax. They’re not getting a deduction, per se, but rather a discount to save money for themselves as well as the Treasury.
Neglecting to keep this in mind can drastically undercut your legacy.
Here’s an example of how:
The Wilsons, have accumulated a nice $20 million estate. Money made over $11 million enters the taxable threshold and is subject to a 40 percent estate tax. Since the Wilsons are in the top federal tax bracket, they would pay 40 percent in federal taxes.
The kicker is that the estate tax doesn’t apply its 40 percent to the remaining amount left over from federal taxes, but rather the total amount. That leaves the Wilsons with only 20 percent of the $9 million that is over the taxable threshold.
Let’s say the Wilsons’ heirs cash out their $1 million 401(k), which makes it subject to estate tax. In addition to paying around $400,000 in estate tax, they would have to pay all the income tax that was deferred when they put it into the 401(k). They’d have to pay the income tax rate on the entire balance, not just the principal.
The Wilsons would be left with about $330,000 of their 401(k) after estate and income tax.
The two taxes combined almost completely negate any benefit of the 401(k). Though the contributions the Wilsons made to their 401(k) were tax deferred on the front end, they were almost obliterated by taxes in the end. Though their life in retirement may not be in jeopardy, their legacy will not give future generations of the family the leg up the Wilsons dreamt of.
When clients realize they will pay estate tax on the embedded income tax of their retirement account, it becomes one of their least favorite assets.
This all sounds like doom and gloom—especially considering the nation is accruing debt faster than it can pay it, making it likely for citizens to face higher tax rates in the future—but it isn’t. These tax traps only pose a danger for those who don’t know to be wary of them. Thinking of taxes on a short-term basis can compromise your entire PFE. At Addicus, we help you conduct your PFE in a holistic, comprehensive way. We believe you should be in control of writing your story and maximizing your legacy.
Like many aspects of managing your wealth, retirement plans are taken for granted as things we ought to do with our money, simply because it’s what everyone has told us our whole lives. Clients often don’t think about it past that. They don’t consider the long-term implications. Again, a tax deduction isn’t nearly as effective as you think it is unless it works within a greater tax strategy that aids your PFE.