The Numbers Don’t Lie…Tax Deferral Is Not As Good As It Sounds

Time and time again we hear it on television, in the financial magazines, from our favorite gurus (Suze Orman and Dave Ramsey) and on the radio…MAX OUT YOUR 401K PLAN.  Chances are you’ve heard it as well so I decided to take a closer look inside the numbers of “maxing out.”

The following is an illustration of the person who religiously followed the advice during their entire working career.   They did everything right and as the financial gurus advised.

Here we have a 28 year old who maxes out their 401k during their ENTIRE working career (age 28 through age 65) AND receives an 8% return every single year that they are invested.  Now that would never happen in real life (something the financial gurus seem to always forget to mention) but in this case I am giving this investor the benefit of the doubt.  The numbers used are the current 2009 contribution limits of $16,500 which is the maximum you can put into a 401k plan this year.  We also assume this investor is in a 30% marginal tax bracket resulting from a 25% federal tax rate and 5% state.  (Skeptics will say the effective tax rate is lower but for the sake of this example just follow the numbers).

Here are the results of the perfect 401k investor:

Years	Age	Total	Beginning	8%	Total	Marginal	Yearly	Amount	Tax
		Contributions	Balance	Earnings	Earnings	Tax Rate	Tax Burden	After Tax	Savings
1	28	$16,500	$16,500.00	$1,320.00	$17,820.00	30%	$5,346	$12,474	$4,950.00
2	29	$16,500	$17,820.00	$1,425.60	$35,745.60	30%	$10,724	$25,022	$4,950.00
3	30	$16,500	$35,745.60	$2,859.65	$55,105.25	30%	$16,532	$38,574	$4,950.00
4	31	$16,500	$55,105.25	$4,408.42	$76,013.67	30%	$22,804	$53,210	$4,950.00
5	32	$16,500	$76,013.67	$6,081.09	$98,594.76	30%	$29,578	$69,016	$4,950.00
6	33	$16,500	$98,594.76	$7,887.58	$122,982.34	30%	$36,895	$86,088	$4,950.00
7	34	$16,500	$122,982.34	$9,838.59	$149,320.93	30%	$44,796	$104,525	$4,950.00
8	35	$16,500	$149,320.93	$11,945.67	$177,766.60	30%	$53,330	$124,437	$4,950.00
9	36	$16,500	$177,766.60	$14,221.33	$208,487.93	30%	$62,546	$145,942	$4,950.00
10	37	$16,500	$208,487.93	$16,679.03	$241,666.97	30%	$72,500	$169,167	$4,950.00
11	38	$16,500	$241,666.97	$19,333.36	$277,500.32	30%	$83,250	$194,250	$4,950.00
12	39	$16,500	$277,500.32	$22,200.03	$316,200.35	30%	$94,860	$221,340	$4,950.00
13	40	$16,500	$316,200.35	$25,296.03	$357,996.38	30%	$107,399	$250,597	$4,950.00
14	41	$16,500	$357,996.38	$28,639.71	$403,136.09	30%	$120,941	$282,195	$4,950.00
15	42	$16,500	$403,136.09	$32,250.89	$451,886.98	30%	$135,566	$316,321	$4,950.00
16	43	$16,500	$451,886.98	$36,150.96	$504,537.93	30%	$151,361	$353,177	$4,950.00
17	44	$16,500	$504,537.93	$40,363.03	$561,400.97	30%	$168,420	$392,981	$4,950.00
18	45	$16,500	$561,400.97	$44,912.08	$622,813.05	30%	$186,844	$435,969	$4,950.00
19	46	$16,500	$622,813.05	$49,825.04	$689,138.09	30%	$206,741	$482,397	$4,950.00
20	47	$16,500	$689,138.09	$55,131.05	$760,769.14	30%	$228,231	$532,538	$4,950.00
21	48	$16,500	$760,769.14	$60,861.53	$838,130.67	30%	$251,439	$586,691	$4,950.00
22	49	$16,500	$838,130.67	$67,050.45	$921,681.12	30%	$276,504	$645,177	$4,950.00
23	50	$16,500	$921,681.12	$73,734.49	$1,011,915.61	30%	$303,575	$708,341	$4,950.00
24	51	$16,500	$1,011,915.61	$80,953.25	$1,109,368.86	30%	$332,811	$776,558	$4,950.00
25	52	$16,500	$1,109,368.86	$88,749.51	$1,214,618.37	30%	$364,386	$850,233	$4,950.00
26	53	$16,500	$1,214,618.37	$97,169.47	$1,328,287.84	30%	$398,486	$929,801	$4,950.00
27	54	$16,500	$1,328,287.84	$106,263.03	$1,451,050.86	30%	$435,315	$1,015,736	$4,950.00
28	55	$16,500	$1,451,050.86	$116,084.07	$1,583,634.93	30%	$475,090	$1,108,544	$4,950.00
29	56	$16,500	$1,583,634.93	$126,690.79	$1,726,825.73	30%	$518,048	$1,208,778	$4,950.00
30	57	$16,500	$1,726,825.73	$138,146.06	$1,881,471.79	30%	$564,442	$1,317,030	$4,950.00
31	58	$16,500	$1,881,471.79	$150,517.74	$2,048,489.53	30%	$614,547	$1,433,943	$4,950.00
32	59	$16,500	$2,048,489.53	$163,879.16	$2,228,868.69	30%	$668,661	$1,560,208	$4,950.00
33	60	$16,500	$2,228,868.69	$178,309.50	$2,423,678.19	30%	$727,103	$1,696,575	$4,950.00
34	61	$16,500	$2,423,678.19	$193,894.25	$2,617,572.44	30%	$785,272	$1,832,301	$4,950.00
35	62	$16,500	$2,617,572.44	$209,405.80	$2,826,978.24	30%	$848,093	$1,978,885	$4,950.00
36	63	$16,500	$2,826,978.24	$226,158.26	$3,053,136.50	30%	$915,941	$2,137,196	$4,950.00
37	64	$16,500	$3,053,136.50	$244,250.92	$3,297,387.42	30%	$989,216	$2,308,171	$4,950.00
38	65	$16,500	$3,297,387.42	$263,790.99	$3,561,178.41	30%	$1,068,354	$2,492,825	$4,950.00
		$627,000			$3,561,178				$188,100.00

Wow!!  These numbers are incredible…I think I may have been mistaken here.  Well let’s delve deeper into the numbers here to see just how incredible this is.  First we see that she invested 627,000 dollars and it grew to over 3.5 million and she saved 188,100 in taxes?  Sounds pretty good…

Now lets keep in mind that this was tax DEFFERAL not tax ELIMINATION so she now has 3.5 million dollars inside a 401k plan that is completely taxable.  So as you can see from the chart IF for some reason she was able to stay in the same 30% tax bracket in retirement (which we know won’t happen because she has 3.5 million dollars) the taxes she would owe are $1,068,354.  Over a million dollars in taxes!!  So the true value of her account is $2,492,825.  I don’t know about you but having to GIVE someone a million dollars even if I have 2.5 left is not a pleasant thought…(that’s how rich people think).

Point #1:  All the money inside your 401k plan does not belong to you!!!  A portion always belongs to Uncle Sam.

Okay.  I know what you are saying…who takes all their money out of the plan all at once?  I am not going to do that.  I am going to take a little at a time out over my retirement.  That will save me money on taxes and allow my account to continue to grow.

Financial gurus always point out that you do not want to spend down your retirement accounts too fast because you risk running out of money.  Basic rule of thumb is count on withdrawing between 4-5% of your money from inside the accounts.  To be safe we’ll choose 4%.  4% of $3,561,178 is $142,447…this is how much she can safely take out of her account and not risk running out of money.

Here is what that might look like:

Years	Age	Annual	Marginal	Taxes	After
		Withdrawal	Tax Rate	Payable	Taxes
1	66	$142,447	30%	$42,734	$99,713
2	67	$142,447	30%	$42,734	$99,713
3	68	$142,447	30%	$42,734	$99,713
4	69	$142,447	30%	$42,734	$99,713
5	70	$142,447	30%	$42,734	$99,713
6	71	$142,447	30%	$42,734	$99,713
7	72	$142,447	30%	$42,734	$99,713
8	73	$142,447	30%	$42,734	$99,713
9	74	$142,447	30%	$42,734	$99,713
10	75	$142,447	30%	$42,734	$99,713
11	76	$142,447	30%	$42,734	$99,713
12	77	$142,447	30%	$42,734	$99,713
13	78	$142,447	30%	$42,734	$99,713
14	79	$142,447	30%	$42,734	$99,713
15	80	$142,447	30%	$42,734	$99,713
16	81	$142,447	30%	$42,734	$99,713
17	82	$142,447	30%	$42,734	$99,713
18	83	$142,447	30%	$42,734	$99,713
19	84	$142,447	30%	$42,734	$99,713
20	85	$142,447	30%	$42,734	$99,713
21	86	$142,447	30%	$42,734	$99,713
22	87	$142,447	30%	$42,734	$99,713
23	88	$142,447	30%	$42,734	$99,713
24	89	$142,447	30%	$42,734	$99,713
25	90	$142,447	30%	$42,734	$99,713
		$3,561,178		$1,068,353	$2,492,825

Point #2:  With a 401k plan you will always have to take out more to NET what you need.

As illustrated she took out 142k but had to pay taxes ($42,734) on the money withdrawn so she only ended up with about 100k.  This is something that is often over looked by 401k investors in retirement….that is the tax factor.  They are unaware of just how big their tax burdens become in retirement and get really frustrated when they don’t need the money but are forced to take it at age 70.5.  There is also something else about this chart that is extremely telling and you probably did not catch it upon first glance (note the orange color).

Look at the tax payments in every year of $42,734  and total them up going down through year 5.  I calculated $213,670 (check my math).  Now recall how much we saved in taxes over 38 years of investing…$188,100.  The picture should be crystal clear to you now.  Uncle Sam gave her a “tax deduction” while she was growing her money and recouped all the tax savings they gave her in 4.5 years of retirement!!  Again this is the perfect world scenario!!!  This is why I always say the devil is in the details…

I’ll take it a step further and ask “what is your tax rate going to be in the future anyway?”  No one knows do they?  Most people believe rates will be higher then they are today.  Well if that is the case?  Then these number get even more scarier.  Our current highest top tax brackets will be 39.6% (from 35%)  and 36% (from 33%) once President Obama changes the top brackets.

Marginal Tax Rate	[Taxable Income] Single	Married Filing Jointly
10%	$0-$8,350	$0-$16,700
15%	$8,350-$33,950	16,700-$67,900
25%	$33,950-$82,250	$67,900-$137,050
28%	$82,250-$171,550	$137,050-$208,850
33%	$171,550-$372,950	$208,850-$372,950
35%	> $372,950	> $372,950

Given the current tax brackets this person will more than likely fall into the new 36% tax bracket assuming being single or having a  spouse that has a retirement plan of their own as well.  After all she alone is withdrawing 142k not to mention a possible pension and/or social security benefits.   So what would the same scenario look like at 36%:

Years	Age	Annual	Marginal	Taxes	After
		Withdrawal	Tax Rate	Payable	Taxes
1	66	$142,447	36%	$51,281	$91,166
2	67	$142,447	36%	$51,281	$91,166
3	68	$142,447	36%	$51,281	$91,166
4	69	$142,447	36%	$51,281	$91,166
5	70	$142,447	36%	$51,281	$91,166
6	71	$142,447	36%	$51,281	$91,166
7	72	$142,447	36%	$51,281	$91,166
8	73	$142,447	36%	$51,281	$91,166
9	74	$142,447	36%	$51,281	$91,166
10	75	$142,447	36%	$51,281	$91,166
11	76	$142,447	36%	$51,281	$91,166
12	77	$142,447	36%	$51,281	$91,166
13	78	$142,447	36%	$51,281	$91,166
14	79	$142,447	36%	$51,281	$91,166
15	80	$142,447	36%	$51,281	$91,166
16	81	$142,447	36%	$51,281	$91,166
17	82	$142,447	36%	$51,281	$91,166
18	83	$142,447	36%	$51,281	$91,166
19	84	$142,447	36%	$51,281	$91,166
20	85	$142,447	36%	$51,281	$91,166
21	86	$142,447	36%	$51,281	$91,166
22	87	$142,447	36%	$51,281	$91,166
23	88	$142,447	36%	$51,281	$91,166
24	89	$142,447	36%	$51,281	$91,166
25	90	$142,447	36%	$51,281	$91,166
		$3,561,178		$1,282,024	$2,279,154

Now it takes only 3.5 years for Uncle Sam to get his money back.  Every year thereafter is a pure profit for the government.  Now can you see why the 401k was created by the government?  I liken it to a person getting a loan from a bank and the bank saying “don’t worry about paying us back until later and when we need the money we’ll let you know how much we are going to charge you for it.”

Point #3: People don’t understand that they could lose nearly 70% (or more) of their account values to federal, state and estate taxes.

People do this every single day by choosing to invest in 401k plans.  They stash away money year after year with absolutely no idea how much they will have to pay in taxes on it in the future and everyone believes taxes are going up.  Also you can’t touch the money until 59.5 years old or you pay a penalty.  You have to ask to take a loan for YOUR money and you can be turned down!  It would seem to me that a 401k plan should have absolutely no strings attached to it.  If a person needs THEIR money they should be able to get it.  After all why are you penalized for getting your money?  Banks do the same thing and it just makes no sense!!!

Someone please help me understand this phenomenon….

Point #4:  The average balance in a 401k for a 65 year old is about $60,000 (a far cry from the 3.5 million illustrated above.)

I hope this sheds even more light on 401k plans and those similar to it.  Knowing what to expect and planning accordingly can help  people to not become victims of the tax trap that awaits them in the future.  So stop listening to the financial gurus as they are only telling one side of the story.  We all need a serious wake up call.

Stay tuned to my upcoming blogs as I will talk about a 401k alternative that you have heard about and paid no attention to that will blow your mind and the financial gurus hate it with a passion…