The Massive, Multiple Pitfalls of
Deferred Compensation Plans
Everyone has probably told you that 401K's and conventional IRA accounts are great because they're "tax-deferred" accounts. I do hundreds of tax returns every year - and I think they are terrible for 95% of all taxpayers. Maybe you're part of the 5%, but odds are against it. Here is what I believe and why...
1) "Tax-Deferred" doesn't mean avoiding taxes, it means that taxes will be paid later. When income tax was started in 1913, it was a "temporary" tax to fund World War I and the typical tax rate was 1%. Today, the lowest federal tax rate is 10%, the top combined federal and state rate is 50% and many are calling for taxes to be higher. The federal deficit - currently sixteen trillion dollars - must be paid for at some point. How else will we ever pay this debt except by increasing taxes? The history of taxes is that, once established, they do nothing but increase.
The "theory" behind deferred compensation plans is you avoid a high tax rate now and pay a lower tax rate later when you withdraw the funds, When you retire in 20 or 30 years and then have to pay taxes, do you really think income tax rates will be lower? Why?
2) Financial uncertainty is a part of life. Unforeseen circumstances occur. And when they do, where do taxpayers get their emergency funds from? Usually, the only thing they have - their retirement accounts. I have seen hundreds of taxpayers withdraw money from their retirement funds and the taxes and penalties on these early withdrawals can be close to 50% of the amount. One taxpayer took out $60,000 and paid $33,000 in taxes and penalties on the early withdrawal. Not worth it!
3) If Social Security survives (I have no idea on this one), the benefits you received are normally tax free - which makes sense, because you paid tax on the money when you earned it. However, Bill Clinton and Congress passed a law in 1992 to tax "rich" senior citizens on their SSA benefits. He defined "rich" as a single person making more than $25,000 or couples making more than $32,000. The law was NOT indexed for inflation - those numbers never change - so eventually EVERYONE will be considered "rich" under this law. And guess what? If you have "outside" income, such was the withdrawal of tax-deferred funds, it can make you normally tax-free SSA benefit payments taxable - again!
When are 401K and traditional IRA Plans a good idea?
1) You should be in a REALLY high tax bracket - combined federal and state tax rates of at least 35% - to even consider benefiting from a tax-deferred plan.
1) You should be in a REALLY low tax bracket - Single filers less than $32K, HOH less than $48K, or MFJ less than $64K (under 2019 tax law). There is a tax credit for 401K and IRA contributions if your income is this low.
1) Your employer should offer a substantial matching contribution - say, 10% or more - to offset the (likely) higher tax burden.
2) You should own your own home. Many first-time homebuyers withdraw funds from their retirement plans to finance their first house. Poor planning and very expensive.
3) You should have six months living expenses in the bank. That's the first thing taught in many investment classes. Before you tie up large amounts of money for 20, 30, or 40 years, make sure you have sufficient savings to cover most emergencies so you won't be raiding your retirement plan, only to lose 50% of it to the government.
So what's the ideal solution?
4) Leave whatever money you have in your 401K or IRA, once the money is in there it's stuck until you are 59 1/2 and very costly to take out earlier. Open a Roth IRA. They are tax-free, not tax-deferred, so you will never pay any tax on the earnings. And, if you have a fiscal emergency, you can withdraw the funds after 5 years with no penalties. Talk to someone who specializes in financial planning and consider other tax-free (NOT tax-deferred) options, such as a whole life insurance policy.
Would you defer going to the dentist if you tooth started hurting and you could afford to have it treated? Moral of the story - Putting an obligation off into the future - instead of dealing with it in the present - usually makes it worse. Procrastination is bad. Tax-deferred accounts are a very basic form of procrastination - and the government makes billions in taxes and penalties off the poor people who are forced to raid their retirement funds when they have no choice. Don't be one of them.