The 7 costly mistakes your clients make, Pt. 5: No game plan for 401(k)s, IRAs, and other retirement accountsArticle added by Tony Walker on June 17, 2014
Bowling Green, KY
Joined: March 11, 2010
Ranked: #96 (720 pts)
For most Americans, the 401(k) is their most valuable asset for retirement. Illustrated in the graph below is a 401(k) worth $300,000. Assuming we lived in a perfect world (no taxes on the 401(k) when we take money out), we’d have all the $300,000 to use and enjoy. Unfortunately, we’ve got to deal with our “progressive” tax system that allows the government to take their fair share first (pre-tax really means you’re just postponing the tax).
So there’s the government’s share — bigger than life — as illustrated in the following graph. The question: What are your clients going to do about it? Here are their only options:
1. Ignore it. Imagine your doctor discovering a malignant tumor within your body. You could ignore it, but if you do, all the tumor is going to do is grow and get worse. Your clients could do the same thing with their tax-infested 401(k) or IRA — just pretend the tax tumor doesn’t exist and pray the next president will demand Congress repeal the tax law and give them the 401(k) tax-free (this would be a miracle!).
See also: 9 top tax tips for financial planners
2. Spend it. Yes, spend it. The financial world often tells us not to, but if your clients don’t spend it, Uncle Sam will get his fair share at some point anyway. And at what tax rate? If you’re like most people and believe that taxes will increase, spending it starts sounding better and better. Bigger barns don’t always mean more money in your client’s pocket.
3. Stretch it. The CPAs and technical folks love this option because they contend that the government is “letting” your clients defer the taxes. True, but what if tax rates do go up in the future? And what about inflation — if your clients keep deferring these dollars off into the future, what will they be worth? This idea of deferring the taxes, and only taking “minimum distributions” for the rest of your client’s life and that of their heirs, makes you wonder if deferring the enjoyment of the money is all that it’s cracked up to be. This strategy never allows your client to eat and enjoy the cow. It’s only promising them a little cream off the top, while the financial world gets to use and enjoy the whole thing.
See also: The 7 costly mistakes your clients make, Pt. 1: Paying taxes on the same dollar more than once
4. Insure it. Assuming we can all agree that everyone’s going to die, why in the world would anyone not own some amount of tax-free whole life insurance? In most cases, this is the only way to guarantee tax-free money to replace the tax that will surely be due at death on the 401(k) plan (unless your client’s beneficiaries stretch it).
Life insurance is the only asset that guarantees a certain amount of cold hard, tax-free cash when your clients need it, and not a minute too late when it comes to kicking the bucket. And tax-free beats taxes every time.
5. Convert it. This is when your clients take the taxable cow (their existing IRA) and magically turn it into a tax-free cow. The process is called a Roth conversion and you can help your clients with this. Keep in mind that when and if your clients do convert a traditional IRA to a Roth IRA, Uncle Sam will want his taxes right then and there.
In summary, the tax tumor buried in your client’s 401(k) must be dealt with. To get it out will be painful. Your clients can pay Uncle Sam now, or pay him later; he really doesn’t care. The government will one day get their fair share. Your responsibility is to help your clients learn their options in order to give them and their families the best chance for keeping as much of their hard-earned money as possible. That’s why it is so important for them to work with you — a retirement specialist.
Be sure to talk to your clients about their retirement options. You’ll be glad you did… and your clients will most likely worry less about their retirement as a result.
As Farmer Brown always says, “Why pay taxes if you don’t have to?”
This excerpt was taken from the book "Don't Follow the Herd" by Tony Walker©
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