The discussion of Tax Deferred Investment Plans vs. Tax Advantaged Investment Plans has been an on going battle. If you listen to the media and popular financial experts, you've probably sided with them in putting your money in tax deferred investments, like 401K retirement plans, Traditional IRA, or a SEP.
Could they be wrong? Well, let's take a macro view of this strategy and you may change your mind after reading this article.
So I was in the drug store the other day, trying to get a cold medication. You ever try and pick one of these out? It's not easy. It's a wall. It's an entire wall of cold medication, you stand there, you're going, "Alright, alright, alright, okay, what the hell? This is quick acting, but this is long lasting. When do I need to feel good, now or later?" It's a tough question.
- Comedian Jerry Seinfeld
Let's take 401k investments. You are putting money into the plan before you pay taxes. When you start accessing the cash, that's when you pay the taxes that you had postponed. So, with these investments, you are not saving taxes, you are just postponing the inevitable. When was the last time procrastination was considered a good thing?
Let's look at some figures to get a better picture. Let's say that you invest $1000 pre-tax over 10 years earning 6%. At the end of 10 years, your investment would have grown to $1790.85. Now, you want to access the money and you are in a 35% tax bracket. So that's $1790.85 - $626.80 = $1164.05.
On the other hand, you have another investment where you invest under the same exact conditions except that you pay taxes (35%) on the $1000 prior to investing. Your invested amount is now $650 and it will for 10 years earning 6%. At the end, you will have $1164.05. It's exactly the same!.
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Typically, people like the idea of deferring taxes because they believe they will be in a lower tax bracket in the future.
What many don't realize is that they're working to have the same or higher effective tax rate when they retire.
If you are in a typical household, what are your two biggest tax deductions? They are your mortgage interest and children. On one hand, they may be deferring taxes by putting their money in a tax deferred investment plan. On the other hand, they may be getting rid of their biggest tax deductions by paying off their home and letting their kids move out. (I'm sure some parents would rather have the kids out of the house than the tax deduction.)
Mortgage interest is tax deductible and as you pay off your home, that tax deduction gets smaller and smaller. When your child leaves the house for good, he or she takes that tax deduction along.
The tax strategies are conflicting here. It's like driving down the highway with one foot on the gas and the other on the brake. Don't catch yourself splitting strategies.
Besides, why would you want to be in a lower tax bracket? The goal here is to make you more money, right? Well, if you are in a lower tax bracket in the future, then didn't the plan fail?
Coming into the workforce, I didn't know the history of taxes. When I was younger it never dawned on me that it would ever be important. Today, the understanding of the unpredictability of tax laws is very important.
Tax laws constantly change. So, the future of our tax code is uncertain. According to Robert Castiglione in his book LEAP, the tax code established in 1913 was supposed to be temporary. It was put in place to help pay off accumulated government debt. Could this happen again in the future?
When I put my money in a tax advantaged account, I'm done paying taxes on the money that was contributed. I can predict what I will pay on that money when I take out the contributed funds in the future - $0.
Even with the uncertainty of future tax laws, my predictability with taxes stays firm.
Let's look at an example derived from Missed Fortune 101 by Douglas R. Andrews.
Todd and Kelly Saver contributed $6000 for 35 years to a grand total of $210,000. Since they were in a 33.3% tax bracket for those working years, they deferred paying $70,000 in total taxes. ($210,000 X 33.3% = $70,000).
Remember the figure they deferred in taxes: $70,000.
In 35 years and one month with 7.5% interest, their nest egg grows to the $1 million mark. Assuming the Savers made interest-only withdrawals to keep their $1 million nest egg in tact and still earned 7.5% interest, their yearly income would be $75,000.
They find themselves still in the 33.3% tax bracket (recall our discussion about the Lower Tax Bracket above). Thus, their net annual income after taxes is $50,000 ($75,000 - $25,000). $25,000 is 33.3% of $75,000.
The Savers spend more than 35 years postponing paying taxes via their tax deferred investment in the amount of $70,000. In just 3 years, the Savers would pay more in taxes than the amount that that they spent so long delaying ($25,000 in taxes X 3 years = $75,000). Imagine if they continue to live in retirement for 20 years and how much more in taxes they would pay to Uncle Sam. Ask yourself, "Are you planning your retirement along with Uncle Sam's?"
However, there are strategies that people can put into place to decrease the affects of taxes. First, understand...
If you were a farmer, would you rather tax the seed or the harvest?
Farmers would rather tax the seed. As time progresses, taxes on the harvest will dramatically erode the fruits of their labor. Remember the example above. The longer someone lives and has their tax deferred investment plan in force, the more he/she will be paying in taxes.
Use tax-on-the-seed (tax advantaged) plans to keep the harvest for yourself. Roth IRAs and cash value life insurance fit this mold.
Whether you pay taxes now or later is up to you. The question remains, when do you want to feel good, now or later?
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