The problem with traditional qualified retirement plansArticle added by Lew Nason RFC, LUTCF on August 29, 2011
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On the surface, traditional qualified retirement plans may seem like a good idea because you receive an income tax break on your IRA or 401(k) contributions. But, let's examine these plans in more detail using a traditional IRA as an example.
Whether you are a business owner, executive, or employee, you are probably using a qualified retirement plan like an IRA, SEP or 401(k) plan to accumulate money for your retirement.
On the surface, these traditional qualified retirement plans may seem like a good idea because you receive an income tax break on your IRA or 401(k) contributions. Those retirement accounts grow tax-deferred, and you normally don't pay taxes on these accounts until you withdraw the money during your retirement.
But, let's examine these plans in more detail using a traditional IRA as an example. Assume you have 30 years until you plan to retire. Currently, you can contribute a maximum of $4,000 into your IRA, so you invest $4,000 into the traditional IRA for the next 30 years.
Assuming you are in a 28 percent tax bracket, how much of a tax deduction do you get each year? Twenty eight percent of $4,000 is $1,120, so you will save $1,120 in taxes in the form of a tax break, each year, for the next 30 years. Over the entire 30-year period, you will save $33,600 in income taxes through this IRA tax deduction.
Now, let's assume your IRA investments do phenomenally well, and in 30 years you have accumulated $1 million in your IRA. Now, let's assume you want to withdraw 10 percent from your IRA each year to use for your retirement income — $100,000 per year.
If you are in the same 28 percent tax bracket when you retire, in the first year you will have to pay $28,000 of income tax on the $100,000.
If you've been paying attention so far, this should shock you.
In only the first year of your retirement, you pay $28,000 in taxes. However, you only saved $33,600 in taxes during the entire 30 years you contributed to your IRA. So, you've already spent almost as much as you saved.
More importantly, you'll probably live at least another 20 years in retirement. The problem is that by paying $28,000 each year in taxes, you'll either have to withdraw more money from your account to pay the income taxes — which may mean you’ll run the risk of running out of money during your retirement — or you'll be forced to live on significantly less money during your retirement. And, that’s assuming income tax rates stay the same as they are today. In 20 years of retirement at $28,000 per year, you’ll pay over $560,000 in income taxes, when you only saved $33,600 of income taxes.
It's the same problem whether you use a traditional IRA, SEP IRA, 401(k) or most of the other qualified retirement plans. With almost all of the available retirement plans you are just deferring your federal income taxes until you retire. What you have unwittingly done is created a retirement plan for Uncle Sam, not for you.
A Roth IRA is a step in the right direction, with the tax-free retirement income it provides. But in most cases, the Roth IRA still has too many restrictions and penalties. There is a limit as to how much you can put in a Roth IRA, there is a phase out for higher income earners and there is a 10 percent early withdrawal penalty if you withdraw money prior to age 59½.
How about if you could get the same tax free benefits of the Roth IRA, but you didn't have the contribution restrictions or early withdrawal penalties of the Roth IRA? And what if I added that business owners currently using a SEP or other qualified group retirement plan don't have to make contributions for employees?
And how about if you could get the same amount of income tax deductions in another way without making your investment income taxable later on?
Now, how much better off would you be?
"If you know how to spend less than you get, you have the philosopher's stone."
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