3 Ways to Escape the Tax Deferral Trap (Part 1)

“The difference between death and taxes is death doesn’t get worse every time Congress meets.”

–Will Rogers 

Busting the Myth of Tax-Deferred “Savings” 

Should you be putting money into tax-deferred accounts or after-tax accounts? It’s a big question everyone must consider.

One way we explain tax deferral is to ask, “Would you rather pay tax on the SEED or pay tax on the HARVEST?” When you invest in after-tax vehicles, you’ve already paid tax on the seed. If you are deferring taxes in a traditional 401(k), IRA, or other qualified retirement plans, such as a 403(b), you’ll pay taxes on the harvest.

Unfortunately, many millions of Americans have been led to believe they are somehow “saving” money on taxes by deferring them. Sometimes their accountants or financial planners feel they earn their keep by showing clients how much they “saved.” Yet are they really saving money, or just delaying the pain of paying taxes? Of course, the tax man must be paid, now or later.

An Example of Tax Deferral at Work

Let’s say, for simplicity’s sake, that you have $100k to invest in a tax-deferred or after-tax account, that your investments will triple between now and when you wish to retire, and you are (and will be) in a 30% tax bracket. Consider the example below:

Money saved: $0.

Extra money earned for the broker through commissions and fees? Possibly tens of thousands. Congratulations, you just made someone else’s retirement better! And this illustration assumes your taxes don’t go up!

So which scenario is actually better for your wallet? It depends on two things: your tax bracket and current tax rates. The phrase “you’ll be in a lower tax bracket when you retire” is repeated again and again, yet that doesn’t make it true. Perhaps you plan on retiring on less money than you earn now, and that’s valid. However, we encourage you to save well and think big for a future that inspires you, which is probably not scrimping and cutting corners in your golden years. And if you think that tax rates are going DOWN in spite of our out-of-control national debt and spending, then you’re VERY optimistic!

What makes matters even worse is the false sense of security these inflated accounts give investors. In the example above, $300k feels like a lot more than $210k… yet they will “spend” the same. The whole truth is this: if you withdrew the whole kit and caboodle at once to buy a second home overseas or invest in a business, withdrawing $300k would easily put you in a higher tax bracket, and you’d end up with LESS money.

Can You AFFORD the Taxes?

There’s also the issue of when can you most easily AFFORD to pay your income taxes… when you are working, or later in life when you may live off of your investments? Be careful that you’re not creating a bill today that will be difficult to pay tomorrow.

Seen through fresh eyes, tax deferral is a bit of a racket. You put your money in government-blessed accounts where you have little control and many rules and restrictions. Later, when you want your money back, the government gets to decide how much is yours and how much is theirs, according to that year’s tax code. And now the government (with much lobbying from Wall Street) has made it legal for employers to take money out of your paycheck to place in a tax-deferred 401(k) without so much as a signature of approval. That’s insane! Perhaps even more disturbing is the fact that employers are legally protected if they lose their employee’s money–yet ONLY IF they put qualified plan contributions into mutual funds with proven risk, such as popular Target-Date Funds. 

Now that we’ve debunked the myth that you save taxes by deferring them, you may be thinking, “But I get an employer match I don’t want to give up,” or, “I already have the bulk of my investments in tax-deferred accounts… what now!?”

3 Ways to Free Your Money from the Tax Deferral Trap

Most people don’t want to pull all of their money out of a qualified retirement plan and get socked with a huge tax bill—plus fees! We recommend taking advantage of one of the legal incentives that will help you free your dollars from the tax-deferred environment as painlessly as possible.

While you won’t avoid the tax man entirely, note that in part 2 of this article, we unveil a little-known strategy that may help you save substantially on taxes while also avoiding a penalty when converting retirement accounts from tax-deferred to taxable.

1. Early Retirement Exceptions

If you left work in your 50s to retire or pursue other adventures, you may qualify to begin taking disbursements without penalty.

An Age 55 Exemption may apply if you left work at age 55 or later and participated in a defined contribution plan. (It does NOT apply to IRAs.) Police, firefighters and medics retiring from public service can take advantage of this at age 50 or later. For more information, see this article on the Financial Ducks in a Row website, “Separation from Service On or After Age 55.”

While this provision was designed to allow those who retire early to support themselves through withdrawals, if you qualify, you can also use it to pull dollars out penalty-free (not tax-free) in order to re-invest them where you have greater control.

2. Substantially Equal Periodic Payments

IRS Rule 72t, also known as “a Series of Substantially Equal Periodic Payments,” or SEPP, allows you to take equal distributions from your IRA until you are 59-1/2 (or a minimum of 5 years) without penalty.

There are different ways of calculating what your withdrawal amount should be. You can take a Required Minimum Distribution or use a Fixed Amortization Method, or the Fixed Annuitization Method. A Forbes article, explains the differences. And for more details, see the IRS’s FAQ about SEPPs.

Other provisions of IRS Rules apply to other specific situations, such as disability, home purchase, IRS levy, or higher education expenses for you or an immediate family member. While there may be better ways to fund such expenses, if you’re looking for an opportunity to free money from a tax-deferred account, take it! By redirecting dollars from your qualified plan to expenses, you free up after-tax dollars for other purposes.

As with Age 55 and Age 50 Exemptions, you can use the SEPP provision to re-position your investments. Of course, most qualified plan choices are mutual funds of one kind or another. If you are ready to get off the roller coaster ride of the stock market, there are many options for non-correlated assets such as alternative investments or whole life insurance. And depending on your financial situation, it also might be a good opportunity to save, rather than invest outside of the qualified plan environment. If you are seeking a savings vehicle not subject to unknown future taxes and market volatility, we can help.

3. Balance Your Balance Sheet

Another way to “escape the tax deferral trap” ever-so-slowly is simply to be proactive with your newer investments. By investing after-tax dollars outside of the stock market, you’ll bring greater balance and stability to your portfolio. (You can do this even within a qualified plan with a self-directed IRA.) If your company matches a portion of your contributions, we recommend only investing up to the match. You want to maintain as much control as possible over your dollars and a qualified plan is not the way to do that!

In Part 2 of Escaping the Tax Deferral Trap, we’ll look at Roth Conversions and our new favorite strategy for an innovative conversion that actually reduces the taxes you pay!

Can We Help You Escape the Tax Deferral Trap?

Contact us if we can help you decrease risk and uncertainty in your financial picture. You can email us at welcome@prosperitythinkers.com or book now here. We’d love to help you take greater control of your financial destiny!