There’s always something to howl about.

401(k)’s IRA’s & Urban Myths

In a recent post, Retirement — A New Class Being Created, I predicted a new class of retiree living a life tied to their free and clear home, with little monthly income. It inspired some interesting comments, and a question that is the inspiration for this post. One reader, Eric, was surprised to hear his 401(k) would be taxed when he retired and began taking distributions. So he asked the following question.

Help a young man out here – what tax bite do you speak of? Early withdrawal? I was under the impression that so long as a 401k built up to a certain age (65?) that it was relatively tax free?

Rain on my parade, I’m wearing my parka. 🙂

It’s not Eric’s fault (at least mostly) he thinks his withdrawals would be ‘relatively’ tax free. I’ve had many people in my office tell me what they know on the subject, most of it based on what some expert at work told them. But alas, it is taxed just like you’re being taxed now Eric. And if you’re not taking out what Big Brother thinks you should be by the time you’re in your early 70’s, they’ll make you take out more, or penalize your butt.

That’s when Chuchundra came in to soften things up for poor Eric. Chuchundra then offered some advice to Eric using the number one urban myth out there on the subject. In his comment, Brian Brady recognized this advise for what it was — pure urban myth. Chuchundra said:

If you have a standard, pre-tax 401K or IRA, you pay tax on your distributions. It’s considered regular income. You didn’t pay tax on the money you put in or on the capital gains that money made over the years, so you pay when you take it out. The idea being that you’ll be in a lower tax bracket when you’re retired, so the tax bite will be smaller.

Now that might very well be true for those who followed the Grandpa Economics school of How To Retire With A Free & Clear Home While Learning To Live On Coupons, but I don’t think that’s the end game Eric is shooting for. Here’s another way to put it. If your tax rate is less at retirement than while you were working, there are very few reasons why. For most, it’s simply because the actual income amount generated by your savings isn’t high enough to merit a higher income tax rate. Besides following in Grandpa’s footsteps, it could also be because you knew someone who does what I do. You’re not taxed much because the bulk of your retirement income is made up of either tax sheltered income, or tax free income. Of course, even when the shelter runs out, and it will, the amount of income is so much, you won’t care.

I’m going to resist the temptation to go all complex and sophisticated here, because it’s not justified. I’ll just invite Captain Obvious to this party instead. Here’s what he has to say: If Eric’s income tax rate is less at retirement than while he was working, it means his retirement income is about the same as when he first entered the job market — if not less. In other words Eric — this means your retiring on the salary of a well trained 23 year old bank teller — before tax.

What kinda plan produced that stellar result, eh Eric? If you work hard for 40 years, and retire at 65 at a tax rate less than you’ve been paying, something went awry somewhere down the line. Eric later added this comment:

If you were looking to put a couple hundred a month aside for a 401k or company offered retirement plan, can you address in the article what you would prefer to see it spent on? Tossed in a liquid savings account (which still offers 4-5%) until there’s enough for a small investment?

If you contribute just under $325 monthly for 40 years into your 401(k), and it’s compounded annually at 8%, you’ll end up, more or less, with about a million bucks. Using that same 8% yield you’ll be retired with an $80,000 annual income. Oops, wait a minute. Forgot just one thing.

Since you’ve bought into the whole free & clear home mantra, you now have an $80,000 income with no interest deductions, and your children are of course long gone (no deductions there). You’re retired, so there’s no tax deductions for work related travel, car expenses, classes, tools, etc. In my world we have a term for that — tax wise, you’re running around town in your boxers. Counting state and federal taxes you’ll be lucky to get away with a net of over $55,000. The tax bite is larger when you add your generous Social Security check to the mix. 🙂

Eric, here’s the alternative I promised you the other day.

First, immediately stop contributing to your 401(k) — it’s a scam. Government planners knew they’d collect more taxes from your generation this way. Think about the small amount of income taxes you saved over the years putting a paltry $325 a month into your plan. Now think about paying $25-30,000 a year in taxes for say, 20 years of retirement. (This means I’ve knocked you off at 85 — sorry.) You’ve paid a minimum of HALF A MILLION BUCKS in income taxes over that 20 year period! Do you think you might do better than that?

Ya think? 🙂

Now, since it’s Memorial Day as I write this, my normal tools aren’t available. However, I’ve done enough of these to come pretty close with the numbers.

First let’s name the vehicle I’ll be recommending to you Eric. You’ll be putting your monthly savings into Investment Grade Insurance. And no, you’re not buying insurance as you understand it. You’ll be investing into a policy that will be indexed to the S & P. The S & P has produced an average yield of, give or take, 8% a year for the last 55 years or so. You’ll no doubt agree, that’s a pretty nice track record. I’ll use my daughter as an example.

Turning 23 this July, she’ll be putting $500 a month for the next 20 years into an investment grade policy. When she’s 43 she’ll stop. If she then waits 10 more years, letting it simmer, she’ll be able to retire with an annual income of roughly $100,000 a year — for life — tax free. That’s the rough equivalent of $150,000 a year before state and federal taxes.

Do the same as my daughter. Start out with an after tax figure, based on the $325 a month used earlier. We’ll say that’s about $250. When you can afford more, increase the monthly investment. Though, like my girl, you’ll also probably have an investment real estate basket, there’s nothing like an extra $100K a year — for life — tax free — to sweeten up your retirement. 🙂

A note here: Another monster cool benefit this vehicle affords you Eric, is that upon your death, the built up cash value and/or death benefit isn’t even part of your estate — and therefore not taxable. Your 401(k) will be part of your estate, and, well, you know the rest. And one more cool difference — you can borrow from this policy without paying it back, and there won’t be a penalty. It just keeps getting better and better, doesn’t it?

My guess is, the urban myth about retirement income being taxed at lower rates than when folks were working, started because most folks bought into the whole Grandpa Economics myth. And as we all know — two wrongs myths don’t make a right. (sorry)

Will my daughter own investment real estate? Captain Obvious says it’s a safe bet. When she’s in her 40’s she’ll have who knows how much tax sheltered cash flow generated by real estate. By the time she’s 53 she’ll have the additional $100,000 a year tax free for life. And I’ll be Grandpa to her kids, visiting them on my dime, wherever they live.

For young men and women out there like Eric, I invite you to contact me. I’ll put you in touch with the financial planner on my team. He’ll hook you up big time. Disclosure: BawldGuy makes a total of $0 every time he refers someone to his financial planner. I don’t want his money, I want my clients to have more money in retirement.

And that’s the answer to your question Eric.