Are Tax Deferred Retirement Plans Worth It?
Sorry for asking such a rude question. But it’s time to ask.
As people who work for a living, we’ve all been told about the benefits of tax deferred retirement plans. I’m talking 401(k), 403(b), IRA’s, Loss and regulars.
Constant advertising shows that they are essential. Without a tax deferral plan, we would suffer a poor retirement. With them, our retirement will be endless smiles.
But it’s time to take a look at this gift horse in the mouth.
If you do, you’ll find a surprising percentage of the scheme benefiting the financial services industry and the tax office. On the other hand, we may pay our own taxes and do well on our own.
How is this possible?
Simple: things change. Two big changes have changed the economics of retirement savings.
Key is the introduction and revolutionary success of extremely low-cost exchange-traded funds.
The second is taxes. Retirement withdrawals are taxed as ordinary income. However, qualified dividends and capital gains are taxed at a lower rate. In addition, the withdrawal of our retirement plans is increasingly likely to trigger the taxation of Social Security benefits.
Biggie: ETFs
First of all, from the topic ETF.
The majority of ETFs introduced in 1993 invest in indices. They are structured in a tax efficient manner. Realization of capital gains can be significantly reduced. They also have surprisingly low expense ratios compared to traditionally managed mutual funds.
This cost difference reduces the value of the tax deferral.
Today, it is possible to build a diversified portfolio of ETFs with an average annual expense cost as low as 0.03%. No commission.
It’s easy to build a portfolio with an average cost of 0.07% or less. This is low enough to have minimal impact on increased savings.
Financial services fees work similarly to taxes.
Core ETF costs are part of the 401(k) and 403(b) plan costs.
So it’s not too much of a stretch to see administrative costs as an alternative form of taxation.
But the money goes to the financial services industry, not the US Treasury.
according to “401(k) Average Book”, a regular survey of planning costs, a relatively large plan with 2,000 participants and $200 million in assets costs an average of 0.65% per year. As you can imagine, smaller plans cost more. With his 100 participants and his $50 million in assets, his average annual cost was 1.2%.
At these levels, if you have a portfolio that emphasizes fixed income, your expenses can be equivalent to or higher than a 12% tax rate. Portfolios going through a rough patch are no different.
It’s a beautiful view.
Insurance companies dominate the 403(b) industry. Serving teachers and non-profit workers in the country. These plans often cost 2% per year, and sometimes more.
This is a stark example from Homefront. In 2019, the Texas legislature voted to end her 2.75% cost cap on her 403(b) offerings for teachers in Texas. Prices can be higher now.
You can pay more in annual investment fees than you pay in taxes.
As a result, you may lose more money in fees than you do in paying taxes. In a 403(b) plan, like most plans in Texas, a 2% annual cost absorbs 25% of an 8% return. Functionally, it’s the same as paying taxes at that rate.
Yet, if a single filer’s gross income exceeds $102,025, Texas pays an income tax rate of just 24%. According to the Texas Department of Education, this is about double the minimum annual salary he is paid to a teacher with 16 years of experience.
For teachers filing joint returns, the 24% tax rate starts with gross income of $116,750. According to the website, only 29% of Texas households will earn more than that in 2021. www.dqydj.com.
Texas teachers (not to mention Texas parents and voters) think why the Texas legislature thinks insurance industry benefits are more important than attracting and retaining career teachers should ask whether
But how do you get a return higher than 8%? Of course, higher returns come at a lower cost.
Unfortunately, that is unlikely. Currently, most pension plans target returns well below 8%. They struggle to reach their goals.
How many managed funds outperform the index? Very few.
As I have reported over the years, Standard & Poor’s reports on active management and index funds regularly show that most managed funds do not outperform their designated asset class index. How serious is the failure? Like 90% in a 20-year investment period, try brooding.
But what about employer-matched plans?
At first glance, the fact that your employer may pay you an amount equivalent to a portion of your contributions seems like a generous offset for a high-cost plan. However, employer agreement is not universal.
Worse, employer matching is only useful in the early stages. The more you accumulate, the higher the overall accumulation fee, and the more likely it is that all of your employer’s annual matches will be consumed.
hello tax accountant
The next barrier is two types of taxes. One is inevitable. The other is more and more likely.
A tax deferral is just a deferral. And we pay for that deferral. All income derived from non-loss tax deferral accounts is taxable in the same manner as incoming income.
But paying taxes along the way makes tax on your original after-tax investment easier when it comes out. The tax rate on qualified dividends and realized capital gains earned in the course of retirement will not exceed 0 to 20%. For most taxpayers, the tax rate on qualifying dividends and realized capital gains is 15%.
However, once the tax deferral plan ends, a diligent saver’s tax rate could rise to 22%.
torpedo tax
When the 401(k) plan grew in 1981, another tax issue didn’t exist. Because the tax on Social Security benefits didn’t exist until 1983, he said. At that time, the income base for taxation on social security benefits was so high that only his 3% of all retirees had to pay taxes.
But it was then.
Today, what I called the tax torpedo in 2003 makes up an ever-larger percentage of all retirees. The income basis for taxation of benefits is not indexed to inflation.
That’s a big deal.
Social Security benefits are taxable if half of your Social Security income plus other income exceeds $25,000 on a single return or $32,000 on a joint return. In December 2022, before the 8.7% COLA adjustment, the most common benefit checks were between $2,000 and $2,099. The median payout was between $1,700 and $1,799.
Doing the math, if you earn more than about $12,000 a year from tax-deferred plans, you may be taxable for Social Security benefits.
For every additional dollar you earn from your deferred tax plan, you will need to tax not only that dollar, but also a portion of your social security benefit dollar. Essentially, qualified Plan Savers earn the privilege of paying a premium tax rate on the amount they save.
Just wondering why the Department of Labor doesn’t require notice of tax deferral plans: WARNING! Participating in this plan may result in less after-tax income than you think.
And this tax starts and ends with Social Security benefits, so it’s totally a middle income tax. Taxation ends when social security benefits are taxed.
So what are you going to do?
Understanding what is best is complicated. But I think we can formulate a rough guideline. please:
1. Do not throw your baby out with the bath water. Many large companies have excellent low-cost plans and offer generous matching.
2. But don’t accept the claim that deferred tax accounts facilitate retirement investments.
3. If your income is above the Social Security wage-based cap, tax-deferred savings may work better than the 94% of all low-income workers.
4. If you’re young and can save for yourself, don’t be afraid to avoid tax deferrals. Commit to a regular investment account and go all-in on a wide range of ETFs such as the Vanguard Total Market Index ETF. You pay very little tax when you return home today, and in the future you will mainly pay capital gains tax.
5. The best possible trade is Roth 401(k) invested in the lowest cost ETF. You don’t pay taxes on withdrawals and withdrawals don’t count as income for tax purposes for Social Security benefits. (Unfortunately, this assumes you can trust Congress. Remember, they passed a tax on Social Security benefits just a few years after opening the door to widespread use of 401(k) plans. This suggests they are shrewd or traitors.)
6. Another great deal is employer matching and low-cost index funds.
7. The deals to avoid are 403(b) plans with expensive options and no matching employer.
