Let’s go back to the beginning of 2015. I’m watching financial consultants on television advising viewers to fund their 401(k) to the maximum. The purpose is to defer the tax on that income and cause the funds to be deemed “tax-qualified.” The advisors are so convincing that it must be the best thing to do, right? After all, they are professionals, and they are on TV. But they never discuss the potentially disastrous ramifications their advice could cause retirees – a lack of control of their funds. The TV segment left within me a lingering impression.
At any time, an individual could walk into a financial institution to inquire about opening a retirement account (qualified IRA). He or she reads the glossy brochure explaining how an IRA can benefit them and the guidelines that they need to follow. Nowhere does the brochure discuss the potential consequences that would give a pre-retiree an entirely different perspective about what the account can cause when they retire.
In these circumstances, the information is presenting the participants with how the decision to defer tax will impact them now, today, this year. Recognizing less income today will create lower taxability. However, no one ever discusses the impact of tax deferral and how it will affect individuals during retirement! Are they oblivious, or do they not want to talk about it?
Usually – during the accumulation phase, when a person would typically be utilizing a tax-deferred treatment – individuals have more deductions and exemptions than when they are retired. Generally, when people retire, their children are grown and they have paid off their major debt, such as a mortgage, and have already deducted the interest portion. When retired, Social Security and a pension (both qualified incomes), coupled with a qualified retirement plan (401k), stimulate taxability. The death of a spouse creates an inherited retirement plan and one less tax exemption, creating even greater taxability. The money that was put into a 401(k), or any qualified plan, will be taxed upon withdrawal, including required minimum distributions (RMD). The increase in qualified money used during retirement increases taxable income, increasing your tax bracket and your effective tax rate. Simply put, accumulating qualified assets will create greater taxability during retirement, oftentimes keeping the individual at the same tax rate as before retirement.
Here’s a little history of qualified plans …
The reason we have qualified assets
Qualified retirement plans – 401(k), 403(b), etc. – became popular in the 1980s, beginning with government-deferred pension plans and leading to the public sector, which offered a variety of qualified plans. Qualified plans meet the established rules created by Congress and carried out through the IRS. Employers and employees, in exchange for tax-deferred treatment, or tax credits, follow these rules and regulations. With this in mind, employers saw an opportunity to provide their employees with what appeared to be a great benefit. By not recognizing such earnings as income, the employees’ income will go untaxed; the growth will also go untaxed while compounding until withdrawn during the distribution phase, retirement. Thirty years ago, it was assumed the individual would be at a lower tax rate than in the accumulation phase. That was accurate when you looked at individuals that retired during the 1980s. People retiring then were focused on using funds from Social Security and a pension, along with investments, which had already been taxed. There was little to no tax-qualified contributory plans to speak of; people had employer-provided pension plans.
With the introduction of qualified plans, employers recognized an opportunity to help their employees fund their qualified plan by participating in employer-matching programs, where the employer received a tax benefit for doing so. This was viewed as a win-win situation; employees received additional money that would go tax-deferred, and the employer would receive a tax credit. With this, employers found it beneficial to help the employees fund their qualified plans, which opened the door for the employer to eliminate pensions, creating a greater savings for the employer. This concept was contagious and took off quickly. It was presented as a plan that would help everyone, but no one realized the effect in the long run, retirement.
In the late 1990s, shortly after qualified plans became popular, the Roth plan was introduced. Different from a traditional qualified plan, a Roth will accept after-tax dollars and treat them with the same tax-deferred benefit. However, the Roth plan takes it one step further by not taxing the distribution. This was seen as a great program, and in my opinion it is. But few people take full advantage of it since the initial deposit is taxed.
It is my thought that the Roth plan was approved by Congress since the traditional qualified plans were quickly becoming a major player in retirement planning. Congress came to realize that the American public was unaware of the effect qualified plans would have in individuals’ distant future, when someone might need significant funds, for instance, for long-term care. Congress, with their analysis, knew that by deferring tax they would create greater taxability later since the growing economy would force salaries and wages to increase, which would create greater taxability. The Roth plan was a solution to offset the damage qualified plans had created within America’s retirement portfolio, but few were taking full advantage of this plan.