A defined benefit plan or 401k plan is a great way to shelter money from taxes. While the benefits are well established, a key omission is you have to pay those taxes later. Will taxes be lower or higher in the future?
As recently as 1978 income over $200k was taxed at 70%. Taxes are historically low now. Are we deferring taxes now at a lower rate only to be taxed at a higher rate when we retire? Maybe a more diversified approach is needed.
If we take a quick look at history, the tax code looked much different back in 1978. There were 26 tax brackets. The difference between each bracket was very small. So the idea was defer your taxes until retirement and it would be very easy to drop down in brackets. Today the tax code is much broader. We only have 7 brackets and the difference between each bracket is much larger. This increases the chances that you will be in the same bracket when you retire as you are today. (Assuming taxes don’t go up.)
So if you are in a 33% bracket now and when you retire you are in the same 33% bracket are you better off?
Well, by using tax deferral, you have increased your current cash flow now because you are sending less money to the IRS. You have more money to save, invest and grow your business. The disadvantage, you have delayed paying the taxes you owe until later.
If taxes are lower, you come out ahead.
If taxes are higher, you lose.
If taxes are the same, it is mostly a wash.
(Although your investments balances have hopefully grown beyond what you deferred so you now owe taxes on a larger amount of money.)
There is one more caveat: it is not just the tax rate, but also how much you withdraw from your retirement account.
Example: Let’s say your retirement income is at the top end of the 28% bracket at $183k and you decide to pull out another $100k for a down payment on a condo. That entire $100k is taxed at 33% and you are left with $67k. In a nutshell, taxes can become a big unplanned expense in retirement. (For high net worth individuals they can account for over 1/3 of retirement expenses.)
This is not to say defined benefit plans, 401k and SEP plans are bad things. We are experts in setting these up for clients and we do this every day. However, it is a problem that most advisers, cpa’s, etc never bring up the taxes that are due later so they can be calculated into the planning process. They tend to advise everyone to go “all in” on tax deferral and hope you’re in a lower tax bracket in the future.
A more prudent approach is to “tax diversify” your assets. Create taxable and tax free asset buckets to pull from during retirement.
From a goal setting standpoint we advise clients to try and go 50/50 taxable and tax free on the amounts they are saving per year. This way during retirement, if taxes are high, you pull more from your tax free bucket. If taxes are lower, you pull from your taxable bucket. This can potentially save you 50% or more per year in retirement taxes. You can view before and after examples of tax diversification in the Guide to Wealth For Life available to download at the end of this post.
Either way, taxes get paid. It’s just a matter of how much and when. Good planning can put you more in control.