Enjoy a Satisfying Tax Life! (Part 1)

in #money6 years ago (edited)

Let’s face it: we all have a tax life. And most of us would like to make our tax life more satisfying (or at least less painful). Whatever your views on taxes are, it’s an inescapable fact that our ability to live life on our own terms is constrained not just by how much money we make, but by how much of that money we get to keep.

With this fact in mind, I’d like to debunk one of the most oft-repeated pieces of financial “advice” given to Americans: to max out your contributions to your 401(k) each year. The logic behind this advice is that you’re both decreasing your current tax bill and increasing your future nest egg. Who wouldn’t want that? Yet whenever I read/hear this piece of “wisdom”, I cringe. Now, don’t get me wrong: if you’re in a position to max out your 401(k) (or, depending on where you work, your 403(b), 457(b), or TSP), I think that’s wonderful and you should put that money to work for you - just maybe not all of it in your workplace plan. Because concentrating your retirement efforts in a 401(k) or similar plan could lead you into a world of hurt starting in your 70s. And once you’re in that world of hurt, there isn’t a whole lot you can do for the pain.

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What is this world of hurt? In one word: RMDs (required minimum distributions). After you turn 70½, you have to start pulling money out of your 401(k) at least once a year. This is so that the government can finally tax it. And the government has a timetable of what percentage of your 401(k) you’re required to take out at each age, and if you fail to adhere to this schedule, you’re slapped with a penalty of 50% of what you were supposed to take out! Think about that for a moment: if you’re supposed to take out $5000 this year and you fail to do so by December 31, you’ll owe an extra $2500! And if you think this nightmare scenario applies only to 401(k) plans, think again. It applies to all other workplace retirement plans in which (a) your own contributions lower your tax bill for the year you make them and are excluded from every tax bill thereafter until you cash them out, and/or (b) money contributed by your employer is excluded from your tax bill until you take it out. And it applies to every single type of IRA (individual retirement arrangement) except for the Roth IRA.

Here’s my biggest problem with RMDs. In the financial planning profession, the standard rule-of-thumb for retirees to make their money last a lifetime is to draw on it at a rate of 4% per year. But what’s the withdrawal rate imposed by RMDs? Well, in the first year, it’s 3.6%, but it goes up every year thereafter. At age 80, it’s 5.3%. At age 90, it’s 8.8%! And at age 100, which many of us today can expect to reach, it’s 15.9%!! You can see this for yourself on this official IRS worksheet. Except that they cleverly manipulate the math so that, superficially, it looks like you're paying less each year. (If you’d like to see how they’re manipulating the math, let me know and I’ll be happy to explain.) Which means that if that 401(k) or other pretax account is your primary source of income in retirement…

See why I have a problem with RMDs?

Now, I am not telling you to avoid 401(k) plans or other pretax accounts. In fact, there are valid reasons to put some of your money into a pretax account (which I’ll address in future posts). What I’m warning you against is concentrating your pool of retirement money in pretax accounts. Which, unfortunately, many people have done because they bought into the hype that the 401(k) is "the only retirement vehicle you'll ever need". (If you find yourself in this situation, I'll be addressing that too in a future post.)

Where else can you your put money? That, my friends, is the subject of Part 2. Stay tuned!

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@benrosenthalft i was going to write a tax guide per tax code. Most who file 1040ez over pay in taxes as the base is different.

Good read, though. Yes lets keep our tax life simple

@ihashblox, if you were planning to write something to help keep 1040EZ filers from overpaying, please do so! I look forward to seeing it. My post here was just meant to alert people to the dangers of putting too many of their eggs in the pretax basket, while the second half will offer some thoughts on how to invest outside of pretax accounts. In other words, these two posts are about making tax-efficient choices in investing, whereas it sounds like what you're talking about is how to optimize your taxes when filing each year.

Yes, what you wrote here is beneficial. Serious. Too much pre tax is just as bad as not enough. I'll tag you in my post. Cheers!

I am a big fan of Robert Kiyosaki. It is insane that they flipped the burden of taxes to the working class with the Liberty tax (that was supposed to be temporary). Then they added lots of laws that enable, as Kiyosaki talks of corporations to pay taxes last instead of off the top.

Great post, looking forward to more of your insights.

I too am a fan of Robert Kiyosaki. Thank you for the encouragement!

It's appealing not just strong!

This is appealing and sick :-)