Hi everyone! Glad you could join us today. We’ve got kind of a podcast/videocast thing going on and glad to have you with me. This podcast is going to come out on Wealthy and Wise Wednesday, the day before Thanksgiving. So tomorrow is Thanksgiving. I hope you have a really good one. I hope you’ve got a lot to be thankful for and I hope you have family and friends around you to enjoy the day. So happy Thanksgiving to you.
Now, on a depressing thought, no just kidding. I am going to talk a little bit about why I think the IRS will likely win. Just from the title alone, you probably agree with me. Have you ever played a game where you just knew the odds were stacked against you?
One of the first things that comes to mind is the slot machines in Vegas. Every once in a while there’s a winner, right? But for the rest of those who try, they can just watch their money go bye-bye as they pull on that lever. But do you think that Vegas set out to say, “Hey! Let’s set up some slot machines and let’s rig it so that we lose. And that all those who pull down that one-armed bandit is going to win.” Well, I don’t think so, and I’m sure you don’t either.
So I often wonder if the IRS sets up systems where they rig it in order for them to lose. Do you think that’s going to happen? Yeah, I don’t think that’s going to happen either. They know the odds. They know what’s going on. They have the statistics. They have the data backing up. And they know what’s in their favor. And so, I want to talk a little bit about this when it comes to retirement plans.
Retirement plans do this really unique thing called defer your taxes. Another word for defer that I like to use is called postpone. That’s a little bit more realistic visually. Deferred, I don’t know, it just seems like that’s not quite as impactful. But when you just postpone your tax, it gives you the feeling that you’re going to be paying that at some point.
And when it comes to a 401(k) in particular, I will quote the 401(k) retirement gain, you always have a silent partner. And you know who that silent partner is? Yes. It’s Uncle Sam Johnny IRS, right? They are always your partner. Anytime you postpone or defer taxes, what you’ve done is take in the amount of money that you would normally send to the IRS that year and you mingle it or commingle it with your money in the same account.
Oftentimes, you see somebody with… let’s just say they got a million dollars in their retirement account and I’ll say, “Wow! You’ve got about $700,000 in your retirement account.” And they’ll say, “No! I’ve got a million dollars.” I say, “Well, actually you don’t because you’ve got a silent partner in there. And at some point, that silent partner is going to want their share. And in your case, at a 30% tax bracket, that means you’re going to give up $300,000 at some point some time when you start taking distributions.”
So really the only way to win in a retirement plan is this…are you ready? Here’s the secret. The only way to win—you have to put your money in or defer or postpone your tax at a higher tax bracket than when you take it out. That’s it. That’s the only way to win.
If I put my money in at a 30% tax bracket and take it out at a 25% tax bracket, I’m going to win because I normally would have paid it at 30, I’m going to end up paying it 25. I get that spread of 5% and that comes back to me so I won. I’ve pulled the lever and I won.
However, if I put that money in at a 20% tax bracket and then take that out at a 25% or 30% tax bracket, guess what? I lose. I just pulled the one-armed bandit and watch my money go bye-bye. I would have been better off paying the tax earlier when I was in a 20% tax bracket than taking it out at a higher tax bracket.
So it’s pretty simple, pretty straightforward. There’s only one way to win. I have to take out my money at a lower tax bracket than I put it in. If I take my money out at a higher or equal tax bracket, it really did me no good to defer or postpone those taxes.
And see, my point is that I think the IRS, well, I know the IRS realizes this, they also realize that there’s probably going to be a few who win just like in Vegas but they have a pretty good idea that you’re not going to be in lower tax bracket. In fact, you might be in a higher one.
And here is what’s interesting. You take a young couple just out of college, they’re going to go get their first jobs, it’s their first career position if you will. And one of the first things they do is run them into HR department and get them signed up for the 401(k) and talk about deferring tax and all the money that they’re going to build up and wealth on and on and on.
The problem is they may be in the lowest tax bracket that they’re ever going to be in or certainly might be in for years and years and years. It might be much better for them to just go ahead and get rid of the tax now and get it out of the way than to defer it or postpone it for 10 or 20 or 30 years and come out in a higher tax bracket. So the real dilemma if you will to a 401(k) and IRA or anything where you defer the taxes upfront is—am I going to be in a lower or higher tax bracket when I take it out.
While back, we asked a lot of CPAs. We brought them into our office. We did a little interview with them. We were asking these CPAs. Tell me about retirees that you work with? Are they really in lower tax brackets when they retire than they were when they were working? And sadly, they said that if there was any amount of success in the family, they weren’t. In fact, most of them were at least in equal tax bracket if not even a little bit higher one.
And the reason why they say that it might go up…well, there are several things that could put you in a higher tax bracket when you retire. One is just this government’s insatiable appetite to spend and spend and spend and spend and print money and print money. And that of course, is ultimately going to be affecting our tax brackets. And overall, we’re going to have to figure out a way to get that debt and that spending either under control and paid off or it’s eventually going to require tax brackets to go up.
But there are a few additional reasons why you may not be in a lower tax bracket. When you’re young and when you’re working, which one of the things that they’re typically happening is that you have more deductions and expenses that reduce your taxable income that can keep you kind of in a lower tax bracket.
One of those ways is just having children, just they are a deduction. Actually, they’re a huge expense, right? But they’re technically a deduction on taxes. Another is your home mortgage. While you’re paying off that mortgage, you’re going to have some deductions and some expenses and all that kind of stuff that you get to write off.
But eventually, you’re going to own that home or at least that’s the dream of most people. By the time they retire, they may no longer have that home deduction. And some owned businesses and during that time, while they’re owning the businesses, they again have expenses and deductions that they can work with but finally when they retire with no kids, no mortgage, business is gone.
Now it’s time to pull money out of that 401(k) or IRA and 100% of that money is going to be taxed because you’ve lost all the deductions. They’re long gone. So if you’re fortunate enough to have a pension, that pension is also going to be taxed. If you take distributions from a 401(k) or an IRA, other retirement plans, that income is going to be taxed.
And what matters even worse is if you have too much income, this is just incredible, that this is even an issue, but if you have too much income, then part or all of your social security can be taxed as well. So it’s really going to be hard to get out of taxes when you’re retired with no mortgage, no children, no business, and no deductions. And if you think municipal bonds are going to save you because they’re tax-free, did you know that the income on municipal bonds is added back in to calculate whether or not your social security should be taxed or not.
Yes, it seems like Uncle Sam has you covered. No matter how you do this. So now, you can see why it’s not unusual for someone who’s retiring to be in about the same tax bracket that they were when they were working and again, in some cases, even higher. Do you remember, if you’re a little bit older, there used to be a Fram oil commercials? It said that…and the mechanic all greasy, he says, “You can basically pay me now or pay me later.” And the message was it’s cheaper to pay me now because while your car is just in a maintenance phase than to wait for a big repair to come along and to pay later.
So the idea was change your oil often and do good maintenance and you won’t have to pay me later. Well, when I think where tax rates were back in the day, with lots of deductions, maybe it was better or cheaper I should say to pay them back then. And we have to assess right now, is it cheaper to pay my taxes now as I fast forward, what I think my wealth is going to be by the time I retire, what my 401(k) is going to be worth, what deductions I may or may not have. It might be a good idea to see if it is a good time to just go ahead and get rid of the taxes now.
A lot of CPAs now are recommending what’s called a balanced tax plan and that means you’re going to have some tax deferred money, some IRA 401(k) all that, you’re going to have some money that’s already been taxed and growing over here. And then one of my favorite ones is to have money that’s already been taxed but in a tax-free environment that if handled properly, you’ll never be taxed again. And that can produce a tax-free income that by the way, does not go against your social security like municipal bonds do.
So there are some different buckets that you can put money in that might make sense and again, have a tax plan before you retire. It’s good to check out all your options. It’s good to look at this far and ahead as possible, 10, 15, 20 years ahead. And build that tax plan because some things take time to build and to grow and to get just into that perfect situation for retirement.
So just because it’s tax-deferred does not necessarily mean that’s a good thing for you. It’s postponed until someday in the future and that someday in the future is when you pay that tax. So one thing to keep in mind that not only is the tax postponed, but the tax calculation. So in other words, today we would calculate it at today’s tax brackets and today’s rates. 10, 15 or 20 years from now, the calculation is going to be performed on the then tax bracket and the then deductions or expenses that you may or may not have.
So again, just like the slot machine, some people are going to win. I hope you do. I hope you’re in a situation where you’re going to win that game. But in a sense, winning the game is kind of losing the game too because I hope your wealth is growing to such an extent that you’re going to have an enjoyable retirement, plenty of money to live off of, plenty of income and typically that also means you’re going to be paying plenty of taxes.
So, to build a strategy, and again, the sooner the better for some tax-deferred, some taxable and some tax-free money, that’s going to help supplement your retirement such a way that hopefully your tax bracket overall will have come down.
I know that’s a lot to take in but that’s it for today. That’s all we’ll talk about. So you’re good to go. If you have any questions, always reach out to me at firstname.lastname@example.org. Make sure you subscribe to our videos. Make sure you subscribe to our podcast. Keep you informed and empowered so that you can make wise financial decisions.
Well, until next week on our Wealthy and Wise Wednesday.
I look forward to talking to you then – take care.