All too often, the income we anticipate in retirement is not the income we receive. This is not due to failing to save enough to retire on, it is due to the lack of consideration given to the cause and effect of taxation on the withdrawals taken as retiree income. We all need to remember that there is always a silent partner in our retirement savings plans, whether they be an IRA, SEP, 401k of any other IRS sponsored form of investment or accumulation vehicle. That partner’s right and proper name is The Department of the Treasury, and we see it exhibited in our lives as the Internal Revenue Service. When we begin our retirement savings in a tax qualified way, we do so for three reasons. One, we simply want to retire eventually and have a decent lifestyle. Two, we understand that no one else will provide for us in retirement, and that is a great motivator in itself. Three, we get a TAX BREAK for saving in a qualified retirement plan. That means we do not pay current income tax on all monies deferred in our qualified plan, and that makes for a great incentive to save. No tax on the contributions, no tax on what may be decades of compound interest as the assets grow. In fact no tax until you withdraw the money as income after you retire. Therein lies the trouble.
By taking advantage of the tax laws that allow such deferral, we forget that eventually the tax must be paid. We believe that retirement will place us in a lower tax bracket, and that the tax we avoided earlier will be paid at a lower effective rate than when we earned the principal and while it compounded over the years. However this has turned out to be far from the truth for many retirees that planned properly and accumulated substantial savings to live on. When we retire we lose so much of the protection that the tax code provided us when we worked and saved. The home is paid for. The kids are grown and gone. The business is sold and that removes the shelter of being self employed (If applicable). We lose TAX DEDUCTIONS. We find that the pennies on the dollar we saved in tax while we accumulated our retirement savings are now being paid back many fold. Sadly, the dime per dollar we may save in taxes when we fund our retirement at age 35 may cost us two dollars or more when we withdraw the contribution and its tax deferred compound interest at age 65 and later. If an individual does not get a clear understanding of the effect of future taxation when they make the CONTRIBUTION, they unwittingly create an infestation of taxation within what may amount to their largest invested asset in life. I don’t know about you, but I have never met an infestation that I considered beneficial to me, whether financial or otherwise!
I look at it this way, rather like the parable of the two farmers. One apple farmer, before breaking ground, makes a compact with the king that allows him to avoid taxation on the seeds he plants, with the agreement that the harvest reaped every year will be subject to taxation, however he does not know the extent of that taxation when he plants. He saves a reasonable amount in current tax and is able to use that revenue to buy more land to plant. A second apple farmer, right next to the first, before breaking ground, makes a compact with the king that he will pay a reasonable tax on every seed planted now but avoid taxation on all of the future harvest. This way the king is able to obtain a current tax and also a future tax based on his agreements with the two farmers. Now the second farmer, since he pays his tax as he plants, is not able to buy more land, and his orchard is smaller than his neighbors. Year pass and both farmer prosper. It is time for the first harvest. Farmer one harvests and pays his tax to the king. He is left with two thirds of his harvest. The second farmer harvests and while the bounty is only 90% of his neighbors, he pays no tax on it. Which one is in a better position of net proceeds? Farmer two!
The moral of the story is that we NEVER know what our tax rates will be in the future. Is it prudent to hedge and create assets with the tax paid on the principal and not on the future income? Of course. One should not only diversify their investments for a better overall return and lower volatility, they also need to diversify their TAXATION. The cost of taxation is based on the tax code when you withdraw your income, not when you save it for tomorrow. Ask yourself. Have your taxes reduced at all over the last 20 years? Do you think that they are more likely to increase or decrease between now and your anticipated retirement? If you believe not, then the path of the first farmer is the one to take. If you believe they will increase, then perhaps a combination of the two methods is a better path to follow. Current tax advantage via deferral, and future tax control via paying some of it on the seed and not the harvest. Just some food for thought
Source: "Tax Free Retirement" by Patrick Kelly
This information is based on current tax laws
Jason R. Lund
CA Insurance License 0808110
35713 Pecan Tree Lane
Murrieta, CA 92562
Advisory Services Offered Through Client One Securities, LLC an Investment Advisor. Lund Financial and Client Securities, LLC are not affiliated.