With the baby-boomers reaching or nearing retirement and the millennials entering the job market, retirement planning is a major topic of conversation. Decisions made in our twenties can have a tremendous impact on our retirement outcome, yet that time for many of us, has passed. There are many ways to save for retirement and the most important decision is simply to have a plan and then to execute it. Virtually any plan is better that none. Having said that, there are some obvious differences in how the various retirement plans work and how taxes are paid. Not all retirement plans are created equal. All plans can be divided into one of three categories; taxable, tax-deferred, or tax-free.
Taxable Retirement Plans
Taxable investments receive a 1099 at the end of the tax year and are paid with your income tax return either as ordinary income or capital gains. These investments are usually in banks in the form of savings accounts or Certificates of Deposit (CDs), or in the stock market in individual stocks, bonds, or mutual funds. Bank investments are very safe, but they do not offer much growth. Currently they pay less than the rate of inflation. The stock market provides good growth potential in the long term, but your entire account is at risk. The closer you get to retirement the greater effect market risk plays on your portfolio.
Tax-Deferred Retirement Plans
Tax-deferred accounts are funded with pre-tax dollars and are allowed to grow tax-deferred until withdrawn (or beginning at age 70 and a half). The amount withdrawn is added to any other income including social security and is subject to ordinary income tax. Pension plans, 401(k), 403(b), 457, and IRAs, are among the most common tax-deferred plans. Most of these plans invest in mutual funds and are subject to the same risks mentioned above.
Many of the baby-boomers were “sold” on “tax-deferred” retirement plans that allow you to invest a portion of your income without paying income taxes at the time the money is earned, it then allows it to grow tax deferred until you retire and then pay the taxes on the money that is withdrawn. The thinking was that after retirement your income will be lower therefore you will be in a lower tax bracket and therefore pay less taxes. The reality according to my retired clients, is that they require just as much income after retirement to retain their life style or the life style they would like to live. This is also a function of inflation. For some time we have been experiencing a modest 3 to 4% inflation rate. But, over a 40 year working life the cost of goods would on average doubled twice. In other words, the buying power of $50,000 forty years ago would require an income of about $200,000 today. Taxes must also be taken into account. With the United States $17 Trillion dollars in debt, many people predict that taxes will have to go up in the future. Also, the main tax deductions relied on by most tax payers are interest on their home’s mortgage and the deduction and tax credit for children. But, by the time they retire many couples have paid off their mortgages and their children have long since reached an age where they are not eligible for the deduction or credit.
Tax-Free Retirement Plans
Tax free investments are funded with after-tax dollars, grow and may be withdrawn tax-free. The two most common tax-free retirement plans are the Roth IRA, and a properly funded Life Insurance Retirement Plan (LIRP). Roth IRAs suffer the same risks as Tax-deferred IRAs, while LIRPs either pay a dividend, or have an indirect participation in the stock market. In either case, once your account has been credited, it is not subject to risk.
Remember, the main reason for a retirement account is to ensure adequate money to fund your retirement, not to reduce your tax liability in your working years. Although many seek the immediate gratification of the tax-deduction. It might be wise to pay taxes on the smaller contribution you invested during your working “accumulation” phase, rather than the much larger amount taken out during retirement. We sometimes ask people would you rather pay taxes on the seed (investment going in), or on the much larger harvest (amount of funds coming out after retirement).
Taxable Retirement Plans
Taxable investments receive a 1099 at the end of the tax year and are paid with your income tax return either as ordinary income or capital gains. These investments are usually in banks in the form of savings accounts or Certificates of Deposit (CDs), or in the stock market in individual stocks, bonds, or mutual funds. Bank investments are very safe, but they do not offer much growth. Currently they pay less than the rate of inflation. The stock market provides good growth potential in the long term, but your entire account is at risk. The closer you get to retirement the greater effect market risk plays on your portfolio.
Tax-Deferred Retirement Plans
Tax-deferred accounts are funded with pre-tax dollars and are allowed to grow tax-deferred until withdrawn (or beginning at age 70 and a half). The amount withdrawn is added to any other income including social security and is subject to ordinary income tax. Pension plans, 401(k), 403(b), 457, and IRAs, are among the most common tax-deferred plans. Most of these plans invest in mutual funds and are subject to the same risks mentioned above.
Many of the baby-boomers were “sold” on “tax-deferred” retirement plans that allow you to invest a portion of your income without paying income taxes at the time the money is earned, it then allows it to grow tax deferred until you retire and then pay the taxes on the money that is withdrawn. The thinking was that after retirement your income will be lower therefore you will be in a lower tax bracket and therefore pay less taxes. The reality according to my retired clients, is that they require just as much income after retirement to retain their life style or the life style they would like to live. This is also a function of inflation. For some time we have been experiencing a modest 3 to 4% inflation rate. But, over a 40 year working life the cost of goods would on average doubled twice. In other words, the buying power of $50,000 forty years ago would require an income of about $200,000 today. Taxes must also be taken into account. With the United States $17 Trillion dollars in debt, many people predict that taxes will have to go up in the future. Also, the main tax deductions relied on by most tax payers are interest on their home’s mortgage and the deduction and tax credit for children. But, by the time they retire many couples have paid off their mortgages and their children have long since reached an age where they are not eligible for the deduction or credit.
Tax-Free Retirement Plans
Tax free investments are funded with after-tax dollars, grow and may be withdrawn tax-free. The two most common tax-free retirement plans are the Roth IRA, and a properly funded Life Insurance Retirement Plan (LIRP). Roth IRAs suffer the same risks as Tax-deferred IRAs, while LIRPs either pay a dividend, or have an indirect participation in the stock market. In either case, once your account has been credited, it is not subject to risk.
Remember, the main reason for a retirement account is to ensure adequate money to fund your retirement, not to reduce your tax liability in your working years. Although many seek the immediate gratification of the tax-deduction. It might be wise to pay taxes on the smaller contribution you invested during your working “accumulation” phase, rather than the much larger amount taken out during retirement. We sometimes ask people would you rather pay taxes on the seed (investment going in), or on the much larger harvest (amount of funds coming out after retirement).
Below, are two different data comparisons of the impacts of beginning retirement savings at a younger vs. older age. Table 1 represents the impacts of different age at inceptions with the same annual contributions. The later that one starts saving, the less that they'll have as a retirement income if the same annual contributions are made.
Table 2 shows what the annual contributions will need to be based on age at inceptions, for an estimated annual post-tax income of $80,000 after retirement.
Table 2 shows what the annual contributions will need to be based on age at inceptions, for an estimated annual post-tax income of $80,000 after retirement.
Navigating through all the potential investments can be similar to trying to make your way through a mine field, unless you have the guidance of a professional advisor. Professional guidance is invaluable in not only knowing how to make good decisions, but also in knowing what potential hazards may be out there.
My goal is to help you develop a plan that will give you the greatest net (after tax) paycheck when you retire, with the greatest probability of achieving your goal and eliminating the number one fear of retired people, out living their money.
To find out if you are on the right track, or if you could use some guidance contact Russ Morris to review your situation and hopefully you will sleep better at night.
If you haven’t already, check out Russ’ website at www.russmorrisfinancial.com, or contact him directly at 909/714-1830. For a more in depth discussion of this topic, read The Power of Zero by David McKnight.
My goal is to help you develop a plan that will give you the greatest net (after tax) paycheck when you retire, with the greatest probability of achieving your goal and eliminating the number one fear of retired people, out living their money.
To find out if you are on the right track, or if you could use some guidance contact Russ Morris to review your situation and hopefully you will sleep better at night.
If you haven’t already, check out Russ’ website at www.russmorrisfinancial.com, or contact him directly at 909/714-1830. For a more in depth discussion of this topic, read The Power of Zero by David McKnight.
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