QUALIFIED PLANS: A TAX-SAVINGS EVENT?

Let’s take a look at how demographic shifts and economic trends collide with traditional thinking and planning. Everyone believes, and is told to believe, that qualified plans, such as IRAs or 401(k)s, are tax saving vehicles. If people 45 years old were to deposit $2,000 into an IRA, and they were in a 25% tax bracket at that time, what would be the perceived tax savings?

Well, 25% of $2,000 is $500, which one might believe to be the tax savings. If they could earn 10% on this money, the $2,000 deposit would double every 7.2 years. At age 66, they would have $16,000 in their IRA account, and then if they had invested and earned 10% on their tax savings of $500, it would have grown to $4,000 at age 66. Unfortunately, the $500 “tax savings” was subject to capital-gains tax over those 21 years, and they would have paid another $480 in taxes, leaving them with $3,520 in that account.

Now, when they go to withdraw that $16,000 from the IRA at age 66, they would owe taxes on it. If they are lucky enough to still be in a 25% tax bracket when they retire, they owe $4,000 in taxes on the

$16,000, but they only have $3,520 from their so-called tax savings to pay it. If you understand the impact of the demographic shifts, do you believe taxes are going to go up or down in the future? Is it possible that you may retire to a higher tax bracket, let’s say 35%? If that were the case, you would owe the government $5,600 on your $16,000 withdrawal, but still only have $3,520 in savings to pay for it.

You need to remember one important question: Whose future are you financing – yours or the Federal Government’s?

THE EXACT DAY

Would you like to know the exact day that your 401(k) or IRA plan will suffer its greatest loss, and if you knew that day and if you could do something today to eliminate or reduce that loss, would you do it?

Most likely, the day your 401(k) or IRA will suffer its greatest loss is the day you retire and start taking income from these plans. The taxes you will have to pay to get your money out of these plans could be 20%, 30%, or 40% and may be even higher. It may be possible that when you take your money out of these programs you could be in a higher tax bracket than when you deposited your money in the program. The only way you can win in a qualified program is if you retire to the SAME or LOWER tax bracket.¹

Now remember Defining Moment #2: Today, you are probably in the lowest tax bracket you will ever be in for the rest of your life.

You need to remember one important question: Whose future are you financing – yours or the Federal Government’s?

A LATER DATE

Hearing the words “tax deferred” almost creates some idea that a magical moment in your life is about to take place. Qualified plans do not eliminate taxes; they simply defer the tax table to a later date. Do you believe taxes will be lower in the future? Of course not. Government spending and the changing demographics in our country almost guarantee tax increases in the future. Knowing this creates an interesting question: When do you want to take money out of qualified plans? When taxes are the lowest or when they are the highest? Understanding what is myth and what is reality and what is true or not true will change the way you think.

TRUE OR NOT TRUE

If you take money out of an IRA before the age of 59 ½, what happens? Well, you have crossed over into “no-no” land. It is a good possibility that you will be labeled as crazy, and you will have to lay low for a few weeks until that cloud of stupidity hanging over you disappears. For taking the money out of an IRA prematurely, you will be “taxed and penalized” – now go to your room; you’re grounded.

Let’s take a step back, take a deep breath and look at the phrase “taxed and penalized.” First of all, whether you take money out of an IRA before or after the age of 59 1/2, you will be taxed on the money you take out. NO SURPRISE HERE, so you can come out of hiding for a little while. Some professionals confuse the issue of delaying a tax with not having to pay a tax at all. That is just silly.

Perhaps they believe taxes will be lower in the future.

Now, let’s look at the “penalized” portion of our sin of withdrawing money out of an IRA before the age of 59 ½. It is possible to withdraw money from an IRA before the age of 59 1/2 WITHOUT incurring an IRS penalty. IRS notice 89-25-IRB 1989-12.68 section 72t allows premature distributions of IRA funds by using one of the three following distribution methods:

Life Expectancy
Amortization
Annuitization

The life-expectancy method simply calculates the amount that can be withdrawn annually, by dividing your account balance by your life expectancy based on the tables furnished by the IRS. The second method is amortization, which allows you to amortize your account balance based on a projection of what your account might earn over your lifetime. The IRS requires that the interest rate assumed in this

calculation be “reasonable.” For the annuitization method, the IRS also allows withdrawal based on a life-insurance mortality table and a reasonable interest-rate assumption. This method usually generates the largest withdrawal without penalty.

REALLY TRUE

Remember, qualified plans offer a couple of guarantees in most cases, 401(k)s and IRAs are guaranteed to be taxed, and you are the only one at risk in your quest to get higher rates of return. If you can block out these two realities, then I guess these plans are okay.

IS THAT A MONKEY ON YOUR BACK?

In discussing what is true and what we think is true in our financial future, we need to discuss the government. There is no other group of people who will impact your financial future more than the government will. Good or bad, you and I, the taxpayers, will be paying the price and carrying the load for everything they do. You see, the government is not a business that earns money to pay for all their programs. Their real job is to collect money from you and me in the form of taxes to pay for everything they do. They spend all this money with virtually no risk to them.

In this conversation about the government, the goal is not to determine fault, who said what or who is lying. I would rather discuss the position that the government has put us in when it comes to our personal financial futures. The government is playing fast and loose when it comes to the truth and money. The financial burden they have created for us to carry will go beyond our generation and into the next two or

three generations of Americans. To justify their economic spending, the government must calculate the tax revenues they will receive from the un-dead but also the future tax revenues from the unborn.

David Walker wore many hats as the former Comptroller General of the United States, including head of the General Accountability Office (GAO), lead partner on the audit of the U.S. Government’s consolidated financial statements, and the de facto chief accountability officer of the Federal Government. He now travels the nation warning of an impending financial crisis: “I am desperately trying to get people to understand the significance of this for our country, our children, and our grandchildren. How this is resolved could affect not only our economic security but also our national security.”

The truth is, government spending is out of control. It continues to spend about 30% more than it takes in. The truth is, according to David Walker, that balancing the budget by the year 2040 could require cutting federal spending by 60% or raising federal taxes to nearly two times today’s level. The truth is, closing the long-term fiscal gap of the government would require real average annual economic growth in the double-digit range every year for the next 75 years. The U.S. economy grew an average 3.2% in the boom years of the 1990s. The truth is that government decisions have strapped us with a mountain of debt that has enslaved us as a nation, and it seems as if no one is paying attention and no one cares.

I want to encourage you to visit the GAO’s website and “Debt to The Penny,” a U.S. treasury website, for a reality check.

In conclusion, the government’s own audit report states this: “More troubling still, the federal government’s financial condition and long-term fiscal outlook is continuing to deteriorate…addressing the nation’s transformational challenge may take a generation or more to resolve. Given the size of the projected deficit, the U.S. Government will not be able to grow its way out of this problem. Tough choices are required.”

THAT’S NOT A MONKEY ON YOUR BACK – THAT A GORILLA

Can average Americans borrow their way to prosperity? The answer is no. Years ago, America was based on strong family values. We were a “pay as you go” nation that learned the value of income and savings. Today, America has become a nation of consumers that has attached liens and promissory notes on much of its future income. Debt ratios of the average-American household have reached record highs. This is far different than the Founding Fathers of our nation could ever imagine. In the future, there will be unintended consequences in paying for the debts we carry.

Household debt ratios in the United States have increased almost 90% faster than the growth of the economy since the late 1960s when real equity and savings have not been the driving force for economic growth. The growth of the economy is driven by debt.

More American families’ futures are now at the mercy of available credit and interest rates. Many households are more dependent on debt than the income they earn and the cash flow they have. In the past 30 years, inflation-adjusted incomes for males in the United States have dropped about 9%. Personal savings during that same time farm have plummeted to 114% to its lowest level since 1934, during the Great Depression. All the while, Americans have been on a spending binge will beyond the growth of

their incomes. Economist Ludwig Van Meses stated, “There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner because of a voluntary abandonment of further credit (debt) expansion, or later as a final and

total catastrophe of the currency system.” This refers to the end results brought on by reckless expansion of credit (debt).

Controlling and reducing debt is very important. Some in Washington would have you believe that increasing prices dramatically will help control and reduce our use of energy. That increasing the taxes,

on energy will make us conserve more energy. If that is the case, then solving personal debt in the country will be easy. Simply raise the price of everything, so no one can afford to buy anything and give credit to only a very few. Make sense, huh!?

What is true is that spending, whether excessive spending by the government or excessive personal spending, is something that we will have to deal with…sooner or later.

The process of learning and discovering what is true and what is not true in your everyday life can create dramatic changes in your financial future. Understanding how your money works for you, not others, is the center point in changing the way you think. From now on, the way you think will impact your future. It is now time to think about money in your life from a different perspective.

I would encourage you to read “Killing Sacred Cows” by author, Garrett B. Gunderson or “The Ascent of Money”, by Niall Ferguson.