The Tax Deferral Trap

2
Aug

The Tax Deferral Trap

It’s commonly understood that the best place to save for retirement is within qualified plans such as a 401k or an IRA. Ask your CPA, and he or she will likely suggest the same given the promise of deferring taxes to later in life and allowing the money to compound over long periods of time. Some may consider this a tax savings, but is it really?

Well, it depends. For starters, the tax deferral is really a postponement of your tax bill to later when you withdrawal the money. While the money is hopefully growing in value, there is essentially a tax lien applied to your account at a future tax rate that is unknown. Your business partner (aka the government) will let you know how much tax they need when you decide to use your money. Also, most of the typical plans only offer the ability to invest in stocks, bonds, and mutual funds which adds additional volatility and risk to your retirement.

Here’s a simple example to illustrate:

Let’s say you contribute $10,000 to your 401k plan through pre-tax contributions. This lowers your current year taxable income by $10,000 and with an assumed tax rate of 25%, you would have paid $2,500 to the IRS, but it’s now postponed and sitting in this account.

Fast forward to later when your account has doubled to $20,000…yeah!. If you withdrawal this amount, and the current tax rate is the same 25%, your tax bill will be $5,000. So where’s the tax savings?

Many are assuming their tax rate will be lower in retirement when they withdrawal their money. Yes, this could be the case if you have some strategies in place to exit these accounts with the least amount of tax. However, many are simply betting on the fact their tax rates will be lower despite not having put these strategies in place.

What does history tell us about tax rates?

If you look at the graph below, we are actually at very low tax rates compared to historical levels. Given all the government spends on social programs and defense, how can they keep tax rates so low? One way is to continue borrowing as we’ve seen with the government debt rising to an astronomical $21 trillion and growing each year. With more than that amount tied up in qualified plans, many experts think the government could easily target these accounts to raise more tax revenues.

Therefore, it’s important to not only consider how to balance the types of investments you have but also the types of accounts (e.g. taxable, tax-deferred, and tax-free). Having balance across them will offer you more flexibility and control when tax rates change in the future.