The Hidden Truth About 401K's and IRA's

Written By: Terrance J. O'Brien
March 27, 2009

401K’s and IRA’s, often called Qualified Plans, are  tax-postponed savings accounts sanctioned by the federal government. 

Retirement accounts do not avoid taxes they simply postpone taxes. You will pay taxes when you start withdrawing from your account.

Uncle Sam is only concerned about your tax bracket at the time of withdrawal.

• You will not know the exact amount of the taxes owed until you start withdrawing the money.
• The tax calculation is also postponed until withdrawal time.
• Your tax bracket play, at time of withdrawal, determines the amount of tax to be paid.
• The tax bracket at the time of contribution is not used at the time of withdrawal and tax calculation.

Unfortunately most Americans can’t live on the money they make during their working years. Most people believe they will be in a lower tax bracket when they retire and will benefit by paying less taxes. The government claims that most people can live on about 66% of their current income during retirement. Living on 1/3 less in retirement might be very difficult and not realistic. 

Many other factors including unfunded government entitlement programs, government bailout's and rising retirement medical costs may have a significant impact on future tax brackets. The cost of goods and services will also continue to rise even with modest inflation. This will put additional pressure on money needed in retirement. 

Are you really saving taxes when you contribute to your 401K or IRA?

It is impossible to determine the tax savings during the contribution phase because of your unknown future tax bracket. The calculation can only be determined once the withdrawals are taken. The uncertainty of your actual tax bracket at withdrawal and the uncertainty of the future formula for calculating taxes are unknown factors. This should be an alarming concern.

 You lose if your tax bracket is higher during the withdrawal phase.

Let’s assume you just retired and decided to withdrawal $10,000 from your retirement account.  You are currently in the 35% tax bracket. Initially you were in the 25% tax bracket. Your tax obligation would have been $2,500 at the time of contribution. You will owe $3,500 in taxes at time of withdrawal. This is a 40% increase in your tax obligation.

Liquidity Use & Control

Your qualified money is not very accessible if you have a need for cash. You are unable to withdraw the money until age 59 ½. Exceptions do apply but there are just a few. Stiff penalties may apply if you don’t follow the rules. Another drawback is you are mandated to take distributions at age 70 ½ regardless of your need for money or the status of your portfolio.

Know the rules.

You must understand the rules. Your qualified money is under government control. The government decides the rules and the way the game is played. The government also decides when you will take the withdrawals, the amount of withdrawals, and the tax bracket at withdrawal, regardless of your current financial situation. The rules may change at any time with a stroke of a pen. New rules may not be to your benefit.

Summary.

Qualified Plans are tax postponed savings vehicles. You will not know if you have made wise decisions because of the unknown tax brackets at the time of withdrawal. Great investment decisions might be adversely impacted by significantly higher tax bracket. It is important to know all the rules so you make educated choices.

 
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