What is a Qualified Plan?
Nobody likes paying taxes! In fact, most people would prefer to avoid paying taxes today at almost any cost. Many people put their money in a qualifed plan such as a 401(k), IRA, SEP, or SIMPLE retirement account thinking they are saving taxes. What if they did not save taxes, when would you want to know? Watch the enclosed video to discover more on how qualified plans work and what you need to know to make them work best for you.
Your Qualified Plan
Qualified plans are tax-deferred savings accounts sanctioned by the federal government, which is what makes them qualified. Qualified plans provide a tax deduction at the time of deposit. Non-qualified accounts are accounts that do not receive tax deductions at the time of the contribution but may provide tax-favored treatment at the time of withdrawal.
This discussion will focus on qualified plans such as your 401k, IRA, SEP, and simple retirement accounts. Do people pay more taxes than they have to? The obvious answer is yes, but not because they want to. Most people would prefer to avoid taxes today at almost any cost.
Hence, one of the most common recommendations of where to place your money to grow for the future is in a qualified plan or qualified retirement accounts. The most common of these is the 401k. What do qualified plans do?
The number one response is that they defer taxes. If that is what you said they do, you were only half correct. The part you missed is more important to your future than you may realize. So what do qualified plans really do? They do two things. Number one, they do defer taxes, which is the part we are most interested in at the time of our contribution. Number two, they also defer the tax calculation. Let this run past your brain for a few minutes.
Your tax bracket plays a very important role in this discussion. Many Americans focus on the tax bracket they are in today, not the one they will be in when they take the money. The truth is they are both important but most focus their attention only on the contribution. What tax bracket will you be in when you take this money out?
This question should receive more attention than it is getting from most.
Let’s assume you’re investing money in one of these accounts you probably thought doing so would save you taxes. You may have even received information from tax professionals that you will save taxes. The truth is these accounts are not taxed savings accounts at all, but tax-deferred savings accounts. That means that you will pay the tax eventually.
The pressing question is at what bracket. If you take the money out in a lower tax bracket than when you put it in you when you did save taxes, but you cannot know that today. If you have to take it out and you’re in a higher tax bracket, you lose an interesting thought at the time of withdrawal, the IRS is not going to ask you what tax bracket you in at the time of your contribution.
Their only concern is what bracket you’re in at the time of withdrawal of the qualified plan. What tax bracket will you be in during retirement? Higher, lower, or the same? Let’s say you wanted to borrow $10,000 you would ask two questions before you took the money.
The first question would be how much interest do you have to pay? The second question would be, when do you have to pay it back?
If the lender responded by saying, we have enough money right now and don’t need any payments from you at this time, but there will come a time when we will need the money and when we know how much we need, we will be able to determine how much interest we have to charge to get the amount we need.
Would you cash that check? Absolutely not, but this is exactly what we are doing with the government in qualified accounts. They’re not saying you do not owe the tax.
They are saying you can pay the tax later at what bracket. That is a good question. Knowing this information means that it is impossible for anyone to tell you how much money you will save by making a contribution today to a qualified plan.
It’s impossible because they do not know the withdrawal tax bracket. Assume you’re in a 30% tax bracket and you wish to make a contribution of $10,000 to your qualified plan.
The best one could and should say is that the apparent tax benefit of making a $10,000 contribution today would be $3,000. What many miss is the fact that the $3,000 you saved in taxes today will be due at interest in the future. You wrote the check for $10,000 to the plan, but you only have $7,000 in the plan.
The government has their share, $3,000, in the plan as well. Had you claimed the $10,000 in income, you would have paid your tax of $3,000 and received the balance of 7,000. The government is allowing you to defer the tax. You did not save any tax. You did not get a check back in the mail. You simply did not have to pay it today. The money you think you are saving is actually in your qualified account. They understand opportunity costs as well.
They will want their $3,000 back one day at interest. Your share earned interest and so did theirs. Should they decide they want more and taxes go up when you start taking the money out, your share goes down. If the account value grew to $1 million, your share would be 700,000 and the government share would be 300,000 assuming a 30% tax bracket.
If you listen to the wisdom of many advisers, you will hear that deferring your taxes is a good thing because when you retire, you will be in a lower tax bracket. They are not necessarily wrong because most people do retire in a lower tax bracket.
The reason is not the taxes are less during their retirement years, but rather most Americans are broke. Most cannot afford to retire at the same level of income they were making while working. Sad but true. The government reports that you can get by on 60 to 70% of your present income at retirement.
There are few people who will be able to retire on two thirds of what they have a hard time living on while they’re working. The other problem with the myth you will need less in retirement is the fact that many things may cost more in the future. Many believe this factor will not be that large a burden because they plan to have their home paid off by the time they retire.
Let’s assume your home is paid off by the time you retire. Will it be a problem during your retirement if your medical costs are more than your current mortgage payment? Will your property be less during retirement? These are things that few advisors may take into consideration in planning for your future, but may have an impact on your lifestyle during your retirement.
While most people do retire in a lower bracket, remember that you are not most people; you do not have to be one of the most. Don’t misunderstand what we are saying. We are not saying these plans are bad. We are simply helping you understand what they do.
These accounts can be a great source for retirement savings and most people who have access to such accounts should consider using them, especially if you’re getting a company match. If you are not getting a match, what are you getting? Tax deferral. It’s better than trying to accumulate money in a taxable environment, but don’t forget you will pay the tax.
Unfortunately, the money in these accounts is not accessible during your accumulation years. Since you do not have access to the money, you may be forced, like other Americans, to finance major purchases like your car. Lack of accessibility can indirectly have a negative impact on your qualified plan.
Assume you’re earning 8% return and your qualified investment account, but you are also financing the car you drive to work at 8% can you see what’s happening? The interest you are earning in your left pocket in your retirement account is being transferred away in your right pocket. The interest you are earning in your qualified plan at work is being lost on the way to and from work. When you add credit card interest and personal loans on top of the cost to finance your cars, you could find yourself in neutral, meaning you’re losing as much as you are saving.
Unfortunately, many will find that their financial future is actually in reverse. The sad truth is that many Americans will transfer more wealth financing the cars they drive to work than they will have accumulated in their lifelong savings account. There are rules that you need to know about access to this money.
You cannot get in the line to access the money until you’re 59 and a half without penalties. You must get in the line and start taking the required minimum distribution at age 70 and a half to avoid a 50% penalty on the amount you should have taken but did not take.
Who’s helping you with the rules? You remember playing tic tac toe is a child? Who won the first game when you play? it was probably the person who taught you the game. They told you the rules were simply to get three in a row.
You may have lost regularly until you learn the strategies of the game. The government has rules that apply to accumulating money in qualified accounts. Few people understand all the rules before they begin playing. Not knowing the rules may result in losing hundreds of thousands of dollars.
The rules all change when you start withdrawing. The money and if you’re not getting the right information, you may lose much of what you worked so hard to achieve.
If your thoughts were challenged in this information, we would recommend that you sit down with the financial services professional that gave you this video and allow them to help you gain a better understanding on the rules that apply to your qualified retirement account. You should understand that you are not saving taxes, you are simply deferring them and you will have to pay them at some future tax bracket yet to be determined.
Your tax bracket could be higher or lower at that time. Here’s an even more compelling reason to get together with someone who can help you with the rules. What is your exit strategy? Is your plan to pay all the tax? If there were opportunities to avoid paying some of the taxes that you deferred, would you want to know how to do that? We hope this video has challenged you to realize that there is possibly more you need to know about these types of retirement accounts.
What you don’t know about them could be more important than what you do know.
Call today and let us help you with the rules so that you may play more efficiently.