tax deferred accounts question?

Question

I was talking to someone who mentioned that the advantages of plans like 401k's and other tax deferred accounts might not be as good as they seem. lets say im making 200,000$ per year. Id be in the highest tax bracket now. once i retire lets say i have a very substantial savings and i am pulling in maybe the same amount from investment income. wont my tax rate be just as high after i retire since my investment income is so high. from what i understand the point of a 401k is to take distributions after you retire because you should be in a lower tax bracket. but that might not be the case for those who have been socking away money feverishly for 40 years and have a few million dollars in their accounts which throw off a very large investment income. am i seeing this right?

Answer 1

You are absolutely right! Tax deferred acounts is of no use, if you ask my opinion. You pay tax on the money you earn immediately. Then, if you invest that tax effected money and earn some income on it or a capital gain on it, guess what? the IRS & local Govt again take a piece of that money as tax!! Dont you think that's double and sometime striple taxing your money? Its either pay that tax now, or 30 years from now.

The prudent thing to do is to invest ONLY in tax-exempt securities, like Treasury securities & municipal bonds. The return might be low, but its yours to keep it, unlike stocks & mutual funds & Corporate bonds.

true 401K gives you a tax saving now, but when you take out distributions, you get taxed! Roth 401K is no better. However, after saying that, I still contribute to my 401K. Why? here's the secret a lot of people dont know:

1. You can withdraw your vested postion from the 401K plan, anyday, to use it as a downpayment on your real estate purchase!!! No tax any where....

2. Now, if you need the money in your 401K for any other purpose, guess what? IRS has been good and considerate enough to let Plan administrators allow you to take a distribution out of your vested balance in the 401K as a Personal Loan!! The loan repayments get automatically deducted from you paycheck, although after tax. But its still alright. Why? because you are paying the principal as well as interest on the loan...and guess what, the interest you pay increases the return on your money in the plan. This is slightly complex, but trust me, its nothing but taking money from your piggy bank and repaying that loan + interest to yourself! I have tried this and IT WORKS!

But since you have to pay tax when you retire and decide to withdraw funds, make sure you keep minimum money in your 401K plan, just enough to cover you on a rainy day from now until retirement. I contribute only the mimimum allowerd by my employer. A majority of your assets long term should be in municipal or Treasury bonds.

So, although you are right, the above mentioned benefits make 401K plan a great choice towards improving your liquidity and an additional source of funds on a rainy day.

Answer 2

You are right that you won't get the advantage of the lower tax bracket, so it might not be as good a deal for you as for some people. But what you are missing is the extra money that compounding the tax-deferred investment will give you. OK, say the first you socked away $10K into your 401K. If that was post-tax, you'd have had to earn around $15,000 to have the $10K left to invest - on a similar investment, your gain for the year would only be around 2/3 as much. And every year until you take it out, it continues to compound.

You might be happy to know, by the way, that unless you are married filing separately, $200K doesn't put you in the highest federal bracket. Close, but not the highest one.

btw, magnumxcaliber has some very misleading info in his response.

Answer 3

There are no 10% fixed accounts out there!! Perhaps, during the Jimmy Carter 14% inflation days there were some that were 10% but that didn't last but several years and the 14% inflation ate away at the savings to boot. "Tax-deferred" is something like a 401k, 457, or IRA, for example. You aren't taxed on the gains until you withdraw the money. The 10-12% historically you learned is the stock market (generally gauged against a standard such as the S&P 500) average over time. Over the years, through all of the ups and downs, the market averaged 10-12% per year. Some years a lot more, some a lot less - but you get your average. As far as what account to invest in... can't answer. That depends on your personality type and tolerance for risk. A total stock market index (S&P 1500, for example) is a way to be aggressive as safe as possible (open to debate, yes). Good luck.

Answer 4

I am in the same boat as you, and here is the point you are missing. Let me explain it through an example. If someone gave you a loan today and said you could pay it back in 40 years, then you could take that money and invest it and make a profit on it. Now, you will have to pay taxes on that profit in 40 years, but you still come out ahead after paying the taxes. So, if you think about it, the IRS deferring your tax obligation is sort of like giving you a loan, because it is money that you wouldn't have if you couldn't defer the payment. As such, even if you have a higher tax bracket when you retire, you can benefit from earning returns on the deferred tax ("loan") from the IRS.

Answer 5

Nobody knows for sure what the tax rates will be by the time you withdraw funds from your 401k. I think the main point is that you continue to earn dividends, interest on the entire sum, and compounded, so that by the time you are 59 1/2 it will have piled up nicely. Of course you'll then pay taxes on the amount you withdraw. If you do not withdraw, bu the time you are 70 1/2 or so you will be forced to withdraw a certain portion, according to a formula based on your expected longevity and that of your spouse.
Of course there is the Roth Ira, where you deposit after tax funds (on which you have already paid income tax) where withdrawals are tax free.