Don’t Blow a Hole in Your Retirement

Will you be my business partner?

Here are the terms: 

  1. You give me a certain amount of money on a regular basis. 
  2. You have no control over how the business is run. You probably won’t know what the company is doing. You may or may not get your money back. I cannot guarantee you any type of return or even if you’ll get any of your money back.
  3. You bear all the risks, and I make all the decisions.  
  4. If you want any of your money back before a certain age, you must give me a 10 % fee. During this time, I get to keep 1%-2% of the money you give me as a fee. And you will have to pay my other partners 1%-2% a year as a fee.
  5. If we lose money along the way, you cannot claim the loss on your taxes, like most other investments allow you to do.
  6. Even if you find a better opportunity and want to end this partnership, you cannot get your money back out of business without giving me 10% of the value of the business, even if you have already lost money.
  7. I MAY let you borrow this money back from me, but you will have to pay me interest, and I name the terms of this loan.

What problems do you see with this partnership?

It gets worse though.

Our biggest partner is the Federal Government, and they will be able to charge whatever taxes they deem necessary on your income. There are no write-offs and no way to reduce your tax bill. 

Does this look like a bad idea?

Ironically, this is the partnership millions of Americans have. It is called a 401(K) or 403 (b) or other qualified accounts.

Do you still think your retirement plan is a good idea? Let’s dive a little deeper.

From a tax perspective

There are no tax savings for putting money into a Qualified Fund; Ever.

  • We have been taught that by putting money into these accounts we will save money on taxes. The reality is, you only defer taxes from the present rate to what is likely to be a much higher rate in the future. 
  • If you do not like paying taxes today, why do you think you will want to pay them more in the future?
  • When you withdraw money, your qualified plan is taxed at the highest rate possible, the income tax rate. 

Putting Pre-tax dollars in your account does not give you more money

  • On the surface, this sounds great. But the reality is, it’s not true. Compounding fees and compounding taxes both destroy your wealth. 
  • Fees are notoriously complicated and almost impossible to decipher. According to the Bright scope and the Department of Labor, fees compounding in your 401 K can easily devour 30-50% of the money in your account. 
  • The average Fee of 401k is 2.22%, According to Smartasset.com. This means for $100,000 you have in your account; the advisor is charging $2,220 a year for their guidance and services

What is the advisor doing to your account to earn this?

  • Have you ever talked to the asset manager of your 401 (K)? Of course not. Why would you? They do not work for you.
  • As time goes on, the total amount you must pay increases. If your account grows, your percentage stays the same, but the amount you’re paying increases. This is shown in the chart below. 
  • These Compounding fees will eventually cost you hundreds of thousands of dollars over time. 
  • In later years, when your account is the highest, your fees will be compounding at the highest rate. Isn’t this when you need your money the most?

An Example of how fees affect your account

  • Bill, Joe, and Bob Each invest $100,000 in a mutual fund at age 35
  • Annualized return of 8% 
  • At age 65, they get together to compare account balances.
    • Bob, who paid 3%, has $432,194
    • Joe, who paid 2%, has $574,349
    • Bill, who paid 1%, has $761,225

Retirement and your taxes

Let us look at what the fees look like in a pretax and an after-tax account.

  • The later years have less growth because typical financial planning calls for “less risk” in retirement. 
  • Growth continues to stay steady at 4%.
  • While fees continue at 1-2% a year of the balance of the account. 
  • Inflation can be ESTIMATED at 2-3%. 
  • We have no idea what the stock market will do.

Investing with pre-tax dollars will allow the financial advisor to make more money because the fee you pay to them is based on a percentage of the money in the account; typically 1-2%. This may not seem like much, but over time it can eat up half the money in your account. The chart below shows the effect a 1% management fee has on this account. In addition, the fees in mutual funds will typically be between 1% and 2%.

AgeAnnual InvestmentGrowthAccount Value1% Annual FeeTotal Fee
25$10,00010%$11,000$110$110
30$10,00010%$82,747$828$2,689
35$10,00010%$193,163$1932$9,950
45$10,00010%$624,410$6,244$49,956
55$10,0008%$1,475,501$14,755$156,150
65$10,0004%2,676,249$26,762$370,864

 

AgeAnnual InvestmentGrowthAccount Value1% Annual FeeTotal Fee
25$800010%$8800$880$880
30$8,00010%$66205$662$2152
35$8,00010%$154,431$1545$19,530
45$8,00010%$$499,528$4995$49,956
55$8,0008%$1,180,401$11,804$124,920
65$8,0004%2,141,066$21,411$296,695

The example below compares a $10,000 investment in a pre-taxed account vs an after-taxed account.

Based on 25% Tax Bracket. If taxes rise even 1% in retirement, the pre-taxed account will pay more.

$10,000 Invested$10,000 Invested
Net: $7,500Net: $10,000
25 Years25 Years
5% Annual Return5% Annual Return
Ending Balance: $383,351Ending Balance: $511,135
After-Tax Outlay: $15,334/Yr for 25 YearsPre-Tax outlay: $20,445 /Yr for 25 Years 
After Tax: $15,334/ Yr for 25 years

 If you anticipate being in the same tax bracket in retirement as you are in your working years, you should be indifferent between the two types of accounts because both result in the same after-tax income. 

From the government’s perspective, the structure of the traditional retirement account is more beneficial. The government has a lower discount rate than private investors. As your account grows in the market, so does their future revenue stream. 

By allowing money to stay in 401 (K) and other qualified retirement accounts, the government earns more revenue through taxes as your account increases. 

One way to think about it; Would you rather pay the current tax rate on a bag of feed, or would you rather pay an unknown tax on the entire farm in the future? Before you answer this question, ask yourself; do you think taxes will increase or decrease in the future? 

Higher Tax brackets in retirement

Taxes are the biggest drain on wealth. They are an even bigger drain when not planned for correctly. 

One of the biggest myths in financial planning is that you will be in a lower tax bracket in retirement than you are during your working years. This simply is not true.  

Think about it from this perspective: If you have achieved any measure of financial success, you should be in a higher tax bracket. If your investments have achieved any measure of the increase in value, you should be in the same or a higher bracket.   

Even if this was true in today’s environment, what do you think taxes will do in the future? Will they increase? Will they decrease? We don’t know for sure what they will do. 

What we do NOT know:

  • We do not know what the future holds. 
  • We do not know how your income will change between now and retirement.
  • We do not know how much the government will increase taxes in the future. 

What we DO know:

  • We have a massive debt problem in this country and the government loves to spend money. 
  • We have to pay for this borrowing either in the form of taxes or inflation. Inflation is another form of tax. 
  • There are trillions of dollars sitting in retirement plans. 
  • The government changes taxes surrounding retirement plans constantly
  • By deferring taxes, you are making an agreement with the US government for a small immediate tax incentive. In return, you have given them the right to not only tax all your growth in the future, but to do so at any rate they deem necessary. 

Would you rather pay taxes now, when you know what they are, and you can plan for them; or down the road when you cannot plan for them? 

Additional Tax Disadvantages

Your account is fully exposed to changes in the tax law

  • Tax status and tax laws change over time. Do you think the government will increase or decrease taxes in the future? Do you the government will continue spending money? 

Higher taxes on your Social Security

  • The money you withdraw each year can increase the taxes on your social security benefits. Proper tax strategies will allow you to pay a lower tax rate on your social security income

Estate Taxes

  • 401 (K)s are sitting ducks for estate taxes. If you want your spouse to be financially secure, this is not the account to leave behind. You are leaving behind a fully taxable account. What is worse, is that your spouse’s tax bracket will change from the lowest-obligation tax status (Filing jointly) to the highest-obligation tax status (Filing Single) 
    • Each plan has its own set of rules. The most likely scenario is that the plan will require a lump-sum distribution. This distribution will not only increase your spouse’s tax bracket, but it may be subject to local, state, and federal income tax and will be due all at once. There are tax strategies to avoid this. 
    • When a person dies, his or her plan becomes part of their estate and estate taxes may be owed on this as well. 
  • If the plan includes company stock, this gets even more complicated. 

From a Cash Flow Perspective

  • Cash flow is the lifeline of any financial plan, business, or household. Why are giving away control of our money and locking it up? Our money is locked up for the benefit of those managing the fund. It is not locked up for our benefit.  
  • Businesses follow quite different rules than personal finance. Why is that? 
  • Do you think businesses lock up their money? No!
  • Businesses focus on creating cash flow. It’s necessary for daily options, taxes, and operating costs, allows us to settle debts, reinvest, provide a buffer against future financial challenges. 
  • When times get tough, lack of cash flow can lead to the inability to pay our bills. If you need to access money in your qualified account, you have to pay taxes and a penalty to access OUR money. 
  • We have been taught to leave money in an account for 30 years, let someone else control it, and never ask questions. Does this make sense? Businesses do not lock up their cash. Why are we being told to?  
  • Cash Flow is what drives your daily behavior. You do not make financial decisions based on the amount of money in your retirement plan or the rate of return you have gotten for the year.  
  • Cash Flow is real. Numbers on a computer screen are simply numbers until the day you start taking the money. You can create more wealth and pay expenses with cash flow. You cannot do that with Zeros on a screen.  

From a Liquidity Perspective

  • Cash is not king. Liquidity is King. Cash kept underneath your mattress or in a Mason jar in the back yard is losing value due to inflation. Not only that, if you keep your money in the bank and earn interest, you will pay tax on that interest. There are tax strategies where you can avoid paying this income tax.
  • Your money should always be making you money, but you also need access to it in order to capitalize on opportunities when they arise. 
  • Liquidity is an important tool in determining the financial well-being of a business and leads to a company’s financial strength in the short term, as well as the long term. If liquidity is important to businesses, shouldn’t it be important to you? 
  • In a 401 (K) your money is tied up. If you want the money that you put into it, you have to pay a penalty. WHY would you have to pay a penalty to access your money? Perhaps because it’s not technically your money.

 Let’s think about the true cost of having your money tied up. 

  • Lack of cash flow has a high opportunity cost. Your money could be doing something more productive if it were not locked up.
  • Every time the market goes down, you have negative compounding. 
  • Inflation is eating away at your account.
  • You still lose money due to fees. 
  • This has a huge compounding effect on the value of your portfolio. 
  • Fees can eat away half of your portfolio

“But they give me free money”

The small amount of money they give you loses all value when you consider:

  • You are putting your money in an account that has the highest tax rate.  Taxes are likely to increase. There are options to put your money in accounts where your gains are taxed at a lower rate or not taxed at all. 
  • Your investment options are generally not good. By placing your money in accounts that you have more control over, you can control the risk of losing your money and place your money into stocks that have traditionally better returns than what the mutual funds in your plan have.   
  • Your fees are high. You can reduce fees by having money in accounts that you have more control over. 
  • You have control to move your money when the market drops 

Sub-Par Investment Plan Designs

  • Typically, retirement plans are filled with mutual funds and target-date funds. 
  • The average 401 (K) offers 15-30 choices of funds. Most of these choices have higher expense ratios than what you would find through a brokerage of your IRA. 
  • Mutual funds consistently underperform the market. The market may be increasing but that does not mean your 401 (K) is. Your 401 (K) only increases if the investments in the plan are increasing 
  • Usually limited to a few investment options that have been selected by your employer and may not reflect your needs
  • Mutual Funds (Lots of fees)
  • Bond Fund: a mutual fund that invests in bonds
    • Fees
    • Long term bonds get destroyed by rising interest rates
  • Target Date Funds is a mutual fund inside another mutual fund (Lots and Lots of Fees)
  • There is no guarantee that you will ever receive anything from this plan. Your entire retirement is based on something with no guarantees. Do you think that is a good idea? 
  • The fund may lose all, or a substantial part of its value in the market just as you are ready to take distributions. 
  • You are stuck watching your account lose value and there is nothing you can do about it. There are other strategies that allow you to move your money, and  guarantee you a return, no matter what the market is doing

Average Rate of Return

  • According to Investopedia: The Average Rate of Return for 401 (K)s is 5-8%; Based on   60% Equities and 40% debt/cash ( Then you must subtract fees of 1-2 %). HOWEVER, A significant amount of this growth is due to your contributions, not from market returns
  • You cannot spend “Rate of Return”. It is just fake money until you take it out. 
  • Averages fail to account for the true power of losses.  
  • To determine your actual returns, you will need to determine the difference in account value between your start and endpoint.  You will need to account for management fees, taxes, inflation rate, and how much money you put into the account over time
  • The belief that average returns over the long run work in our favor has been at the cornerstone of the “buy and hold” strategy for years. 
  • It’s an unproven truth accepted by almost all of us. 
  • We don’t talk about the losses in your account affect income in retirement the Impact of losses
  • Negative and positive returns of equal amount carry the same weight in determining AVERAGE RATE OF RETURN, but losses in your account have a greater impact on the REAL RATE OF RETURN  
  • Losses are more severe as we get older because of withdrawing money. We do not have time to make it up.

 

Ticking Tax Time Bomb Chart

From the graph above compare the following: 

  1. Bear Market of 1980s to early 1930s
  2. 1929 Peak vs the Mid 1970s vs 2000
  3. 1966 Peak to 2009
  4. The Dow will always have a natural increase. Companies get replaced. Bigger companies replace smaller companies. The Dow started with 12 companies and now has 30.  

After a loss, how much does the market have to increase just to break even?

If you Lose this MuchYou need this much to Break Even
30%43%
40%67%
50%100%
60%150%
70%233%
80%400%
90%900%

Not only do you lose money due to the stock market, fees, and inflation, but you are also losing money due to opportunity costs. Your money could have been making money elsewhere.  

  • The government controls your retirement account by imposing numerous restrictions and penalties if you don’t follow their rules. 
  • Typically, you have to be at a company for 4-6 years to be vested and keep the company match. 
  • Your Retirement plan is at the mercy of the market and at the mercy of the government. 
  • Why are you gambling your retirement on the market performance from now until you reach retirement? And then from retirement to the day, you die?
  • The performance of these funds is dependent on market factors that we have absolutely no control over. Why would you put your money into something that you have no control over? Does that make sense? Maybe it does because this is what you have been taught. But it’s not true. You can still make money on your money AND have total control. 
  • Why are you gambling your retirement on the decisions the US government will make about tax laws?

Is putting your money in the stock market risky? Maybe. Maybe Not. I would argue that it depends on if you are investing in the stock market or gambling in the stock market. To understand what I mean by this, we much first understand the difference between Investing and gambling.  

Any investment can be risky if you don’t understand the investment. Think about the area you’re an expert in or the field you work in. Would you consider it riskier to put money into this area, an area you know well, or riskier to invest in, say, day trading, or real estate? 

I know nothing about the oil industry, so I would not invest in it. I will invest in the stock market and in real estate because those are areas I have experience and knowledge in. 

Risk is more about the investor than necessarily the investment. The difference between the two comes down to is risk control, having a purpose, due diligence, being pro-active, and invest in what you know and understand. 

Characteristics  of Investing

  1. Devoting time and energy to do due diligence  and understanding your investment
  2. Creating strategies to prevent total loss of risked capital.

Characteristics of Gambling

  1. Take Risky action in the hope of a desired result.
  2. Very little to no strategy to mitigate loss. 
  3. The House Makes the Rules

We have established that the government makes all the rules when it comes to your retirement plan. 

Let’s test your due diligence

  • Do you know what a 401 K is?
  • By Definition: It is a section of the tax code. 
  • This means:  The rules around it can be changed at any time
  • The tax rules around retirement plans have been changed many times
  • Your biggest partner in your retirement plan is the Government.
  • How much do you know about your 401k?
  • What strategies do you use to mitigate loss?
  • What strategies do use to get higher returns on your Retirement Plan? 
  • Do you know about the funds you are invested in? 
  • Do you know about the companies you are invested in? 
  • Have you seen their financials?
  • Do you know anything about the fund manager, their history, investment philosophy, or their performance?
  • How much are the Fees?
  • How much are the fees for the investments inside your plan?
  • Do you know your Vesting Schedule?
  • How many years do you have to work at your job to receive a company match?
  • How much does your employer match?
  • Do you have better options?
  • Have you sat down with an advisor to have it analyzed? 

Based on the answers to these questions, do you believe you are investing in your retirement plan or gambling with your retirement plan by putting money into something you know little-to-nothing about, hoping for the desired result?

We have been taught from a young age that a 401 K is the foundation of our financial plan. But Why? The first thing we need to do is think about who benefits most from this? 

What is your 401 (K) really doing for you now or for your future? Of course, we need to save money for retirement, but after reading the above don’t you think it’s possible to find other philosophies, products, and strategies that will give you more control, better exit strategies, reduce your tax burden, and increase your cash flow and wealth?