How Your 401(k) Is Sabotaging Your Retirement — Maybe Postponing It

Posted @ 8:38 pm - Filed under 401(k)'s & IRA's, Financial Planning, IRS, Tax Shelter

What with all the sound and fury concerning the economy in general and real estate specifically, there’s a lesson being taught to literally millions of Americans which has, from where I sit, gone unnoticed, maybe even by those who’ve been ‘taken to school’ on the subject. What am I talkin’ about? Simple — 20-30 years of 4-5% annual returns + small annual tax breaks + large post retirement tax bills = FAIL as a retirement strategy.

I just reduced the 401(k) to it’s bare essence. It’s Uncle Sam’s Purposefully Planned sacking of your retirement income. It’s insidious. The taxpayer is baited with a dollar of annual tax savings — then taxed 3-6 dollars a year when they retire. I wanna be Uncle Sam in that scenario, how ’bout you?

The latest long term (20 years) study of 401(k) performance yielded a report card none of us would wanna show Mom and Dad. It looked at the typical American employee who contributed as much of their income as possible to the company’s Qualified Plan, almost always investing in mutual fund products — this was to ‘diversify’ their investments to ensure ’safety’. Anywho, the annual return for those 20 years came out to be less than 5% — no, really.

Here’s how that will turn out over the next three decades.

Say you discipline yourself to contribute $8,000 annually while getting 5% over that period. You’d end up with just over $530,000. Even if you figured a way to finagle an 8% return on that amount at retirement, it would only be about $42,000 yearly — however that figure is before state/fed income taxes.

Let’s also assume you receive Social Security (no snickering) of about $20,000 a year. That’s a tad over $60,000 retirement income — again, before taxes. Not bad, eh? Not so fast. Let’s make you much more successful, OK?

Over the years I’ve talked with more than a few smart cookies who’ve managed to end up with a couple million bucks in their Qualified Plan. They obviously either had superior advice, or were Wall Street experts themselves. In any case, let’s be generous, and give them credit for the ability in retirement to generate a 6% annual return on the $2 Mil.

That’s $120,000 a year in pre-tax income. They have nothing in the way of tax shelter to offset even a nickel, which means they’re essentially naked every year as they approach April 15th. Imagine if they live in a tax tax tax state like California or, Heaven forbid, New York — City. Not only is the cost of living relatively high, but after paying all their income taxes, that lofty income shrinks fairly quickly. The California taxpayer will see their income shrink $20-30,000.

The reason their after tax income will shrink so much is due, ironically, to the strategy they employed. They literally guaranteed themselves the absence of any tax shelter. Furthermore, wait ’till they get a reminder from the friendly guvmint man about how ‘little’ they’re taking out of the 401(k) each year. It’s just as likely as not they’ll be forced to take more than they wish, AND pay taxes on it. That’s not the worst part though. That increase by definition forced them to begin dippin’ into their principal.

Oops. So unless they can successfully increase the return on the newly reduced amount of principal, their income generated from the return ON their money will drop, while their taxes rise due to the forced income increase. What a racket, eh?

I’ll be talkin’ about some viable, and very realistic alternatives next. But here’s one thing I’d love for you to take from this. When planning your retirement be very cognizant of your projected AFTER TAX return. Pre-tax income is a mirage at best, and a nasty surprise at worst.

Let’s review and simplify by asking a few simple questions.

1. Why would you purposely opt for $100-250,000 in tax savings, spread out over 30 years or more, for the privilege of paying more than that in just the first 3-10 years of your retirement?

2. Is it your intention to retire with the highest possible pre-tax income sans any meaningful tax shelter — for the rest of your life?

3. Do you think taxes will rise or fall between now and your retirement — and/or between retirement and years after retirement?

4. Is it your intention to have that much of your estate virtually halved upon your passing?

As I said earlier, we’ll take a look at a couple strategies you might opt to use instead of guaranteeing yourself an ever falling income, naked to taxation — sometimes at rising rates.

Let’s figure out what’s possible for you and yours. Dial 619 889-7100 and wait ’till ya hear, “This is Jeff”. We’ll take care of the rest together. Have a good one.

This entry was posted on Thursday, July 16th, 2009 at 8:38 pm and is filed under 401(k)'s & IRA's, Financial Planning, IRS, Tax Shelter. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.