Why retirement plans are a big fat tax idiot

Let’s rap about why retirement plans are the basic bitch of the financial industry.

First, the tax “benefits.”

Everyone talks about them. But, where are they?


Enter, the professionals.

The Society of Actuaries (which helps guide the design of pension and retirement plans) tells the general public what most financial planners have known for decades but have never told their clients:

It doesn’t make any difference whether [the taxes] are taken away from you at the beginning (tax-exempt) or at the end (tax-deferred). It’s the same fraction of your money that is left to you.

If tax rates are the same, then it don’t matter whether you invest in a retirement plan or not. Sometimes, even when tax rates are different between now and then it doesn’t matter.

But… what does matter is net retirement income adjusted for inflation in the future vs net income now.

People use retirement plans because they get a tax break right now.

Which means… They see more income now. And… They like that.

I get it.

But… why are you saving for retirement?

If it was just for a tax break right now, there’s an easier way to save more money in taxes: make less money.

But I suspect no one wants to do that.

What people hope is there will be more money for them in the future because they’ll be in a lower tax bracket because their advisor said so.

But this rarely happens.

Deferring the tax usually results in lower retirement income because… remember how your advisor told you that your investments have to beat inflation to grow your savings in real terms?

Well, they was right.

But… what they neglected to add was your retirement income must do the same to allow you to maintain your standard of living.

And inflating your income on a set schedule is problematic (not in an SJW way tho) in a tax-deferred retirement account because all that does is increase the tax you pay over time.

As you withdraw more money to maintain that standard of living, it pushes your income higher which… causes you to pay more tax which… eventually pushes you into a higher tax bracket.

And… it lowers your net income.

Here’s what I mean:

A very mainstream and popular financial advisor (not me, obviously) says it like this:

Let’s say you’re in a 10% tax bracket. If you have $100 to save right now and you pay tax on it, you have $90 left to invest. Now double it. You have $180. But, if you defer tax on that $100 and double it through investing, and then pay the tax you have… $180 — the same amount of money. So, it doesn’t matter whether you pay tax now or later, but it’s probably better to defer taxes in a 401(k) so you have more money to save and spend now.

Here’s what I would add:

Let’s take the same example as above. You have $180 in both scenarios. But, in both scenarios, you also have inflation. So, if you defer tax until later, you go to withdraw $1 in income and you pay 10% tax, you have $0.90. No biggie. This is to be expected. But, next year you need to withdraw $1.03 to adjust for inflation. Now you pay the same 10% tax on a higher dollar amount.

In the first year, you paid $0.10 in tax. In the second year you paid $0.103 in taxes. By the time you’re withdrawing $5 in income, you’re paying $0.50 in tax on your income. That’s OK because it’s still 10% any way you slice it.

But… here’s where things get interesting.

We have a progressive tax system in the U.S. You’ve heard the saying “the more you make, the more they take”, yes?

Your $1 of income might keep you in a 10% tax bracket. But your $5 in income will probably push you into the next higher tax bracket. So, it’s no longer $0.50 in taxes. It’s $0.75 or $0.80. Income thresholds are dollar-based but tax brackets are percentage-based, so eventually you are going to pay more tax after you retire unless you shrink your standard of living into a cardboard box.

Do you see a trend here?

You can very easily predict this in any Excel spreadsheet if you know the current income tax brackets.

And, because of the required minimum distributions from the IRS, you can never not withdraw money from your retirement after age 70. You don’t have to take inflation-adjusted withdrawals of course, until… you can’t afford to buy groceries. At some point, it becomes a practical necessity. So… you can’t get away from it.

And by the time you realize the tax gimmick of 401(k)s and IRAs, it’s too late. You’re old and can’t go back to work and now you’re paying more taxes in a higher tax bracket.

Now, you have two choices: you can stick your head in the sand or… you can figure out how to solve this problem.

To do the latter, go get on my email list and start getting my daily financial tips and advice.

David Lewis, AKA The Rogue Agent, has been a life insurance agent since 2004, and has worked with some of the oldest and most respected mutual life insurance companies in the U.S. during that time. To learn more about him and his business, go here.