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How tax-savvy is your retirement plan?
Legal Disclosure: Tony Robbins is the Chief of Investor Psychology at Creative Planning, Inc., an SEC Registered Investment Advisor (RIA) with wealth managers serving all 50 states. Mr. Robbins receives compensation for serving in this capacity based on increased business derived by Creative Planning from his services. Accordingly, Mr. Robbins has a financial incentive to refer investors to Creative Planning.
What’s your retirement plan? Do you have a pension? A 401(k)? Do you think this will be enough for you to live comfortably on?
While millions of Americans have a retirement account in place, the scary truth is, they have not considered the impact that taxes have on how much of their money they will actually keep.
If you haven’t noticed already, our government has some serious spending habits. They’ve not only racked up more than $17.3 trillion in debt, but $100 trillion in unfunded liabilities with Social Security and Medicare as well. So what do you think this means for taxes? Will taxes be higher or lower in the future?
You have probably been taught to maximize your 401(k) or (IRA) contributions for tax purposes, because each dollar is tax deductible. This of course means that you don’t have to pay tax on that dollar today, but will instead defer the tax to a later day.
Here is the problem: it’s impossible to know what tax rates will be in the future. So you have no idea how big of a bite taxes will take out of your retirement fund.
Most experts will tell you that over time, the only logical way direction for taxes to go is up. After all, someone has to pay for those staggering levels of debt the government has accumulated. What does this mean for your retirement plan? In short, it means that what you actually get to keep could be a lot less than you anticipated.
To help you determine which retirement plan is right for you, we help answer some of the most important questions you may have about the impact of taxes on your financial future.
Q: Should you participate in your 401(k) plan?
A: The bottom line is that you have to do something. But you have to be smart about it. The 401(k) can be a great piece of tax code that, if structured right, can fuel your retirement for years. But, as we see in most of today’s plans, many 401(k) plans are chock full of fees and unseen costs. In 2012, service providers became required by law to disclose these fees, but despite this change, the majority of employees still aren’t aware of how much they’re paying — and really, how much they’re losing.
With that said, if your employer matches your contributions, then it is worth taking advantage of your 401(k), since they are basically covering your future tax costs. Just be sure to know how your company’s plan stacks up. Go to http://Americasbest401k.com/401k-fee-checker and click on “Fee Checker” to assess your company’s plan.
Q: What should you do if you think taxes are going up?
A: If you think that taxes will go up in the future, then you may want to consider a Roth retirement plan. A Roth IRA, and more recently the addition of the Roth 401(k), is often overlooked, but is actually one of the most tax efficient solutions to retirement out there.
With a Roth account, we pay taxes today, then deposit the after-tax amount and never have to worry about taxes again. So our money grows tax-free and we don’t have to worry about taxes when we take our money out. You are completely protected if the government decides to raise taxes in the future. And most importantly, you will know with absolute certainty how much money you will actually have when you decide to start making withdrawals.
Most of today’s 401(k) plans allow you “check a box,” and your contributions will receive the Roth tax treatment. This means you can pay tax today and let your growth and withdrawals steer clear of the tax man. And while a Roth IRA is limited to a $5,500 annual contribution, the Roth 401(k) allows you to deposit $17,500 every year.
Just remember, if you decide to check the box and make your 401(k) contributions Roth eligible, you will still be investing in the same list of funds. The only difference will be that you are paying taxes on the income today, while securing your money from taxes in the future.
Q: Are there restrictions with a Roth IRA or 401(k)?
A: Unfortunately, you cannot contribute to a Roth IRA if your annual income exceeds $114,000 as an individual or $191,000 for a married couple. But, not to worry, no matter how much you make, you can always participate in a Roth 401(k). This is a relatively new change in the tax system which can provide a big benefit for higher income earners.
Q: Is there anything you can do with your traditional IRA?
A: Yes, there is. If you think taxes will be going up in the future, then you may want to consider a Roth conversion. With a Roth conversion, the government will allow you to pay the tax on your IRA today (because they could use the money now), and you will never have to pay tax again. Confused? Take John, for example. John has an IRA with $10,000 and is in the 40% tax bracket. This means he would pay $4,000 today and allow the remaining $6,000 to grow and be withdrawn tax-free!
Some people are automatically turned off from the idea of paying tax today. But remember, you will have to pay taxes eventually. And by doing it now, you are protecting yourself and your nest egg from future tax hikes.
Q: Are there any additional options to save?
A: Small business owners or high income earners that have a steady income and want to reduce their taxes today can find big benefits by coupling a cash-balance plan with their 401(k) plan.
A cash-balance, or CB plan is basically a pension plan that happens to have elements of a 401(k). Like a pension, you won’t be investing any of your own money into the plan. You also don’t have control over the investment choices. But, rather than your overall benefits being based on a specific formula that considers how long you’ve worked at the company or what your average salary has been, the CB plan simply takes a set percentage of your salary each year, plus a set interest rate and adds it into your account. The best part is that you can max out your 401(k) plan and a profit-sharing plan, then still add a CB plan to create some substantial — and fully deductible — contributions.
According to the owner of America’s Best 401k, Tom Zgainer, “a cash balance plan starts to get very exciting when you get older, as you can put a more substantial amount of money away while reducing your tax liability. A cash-balance plan essentially allows you to squeeze 20 years of savings into 10 years.”
Remember, it’s not enough to just protect your nest egg from the unscrupulous fees and costs that some 401(k) plans impose, you must learn how to protect your money from unforeseen changes in the environment, particularly taxes. Whether this means selecting a plan in which you pay your taxes today or one that allows you to defer your taxes until later, you must find a way to optimize your growth and be fully aware of how much you will get to keep. Don’t be blindsided by the hit the tax man will take on your nest egg. Protect your nest egg and protect your road to retirement, because by doing so, you are ultimately protecting your financial future.