Money Talk

Episode 08

Tax Qualified Plans

Deferring self gratification. Protect your money from creditors. IRA’s are great for divorces. Don’t pay Obamacare tax, payroll tax, or State income tax. Don’t invest your money, invest someone else’s. Don’t be a blockhead.

Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in.

Ed: Hi, I’m Ed.

Chuck: I’m Chuck.

Ed: Today’s topic, tax-qualified arrangements. An overview. Why is this an important topic? First of all, it’s important if you can defer some self-gratification. If you’re interested in saving taxes, income taxes it will never be paid, for example, a total of 20% of the amount set aside. Why? You eliminate the federal taxes referred to as FICA it’s about 12.4%. You eliminate the Medicare tax which is about 2.9%. You eliminate the Obama care tax which is about 3.8%. You typically eliminate state income tax. Without regard of the state tax, the total amount rounded is 19 to 20%. If you’re setting aside 100,000 in a tax-qualified arrangement, that’s better than setting aside $80,000 after tax. Chuck, in terms of the ultimate destination of these assets?

Chuck: Yes, well, the idea would be to provide a great deal of flexibility once the assets have been deferred into the tax-qualified arrangement. Then the best design for this would be to provide a great deal of flexibility to be able to each individual participant to be able to direct the investments inside there. Typically, there’s an entire menu of investments that can be selected and really there’s no reason why an employer can’t design a tax-qualified plan to just have an unlimited selection of arrangements as well. Lots and lots of flexibility in there.

Ed: In terms of credit protection, generally speaking, the assets you’ve set aside or you IRA that’s your retirement program, IRA. That serves as a claim to creditors which is a good thing.

Chuck: I had conversations with clients who were interested in avoiding or in securing assets in a way that they would be beyond the reach of potential creditors. This is typically people who are in licensed professions, a stereotypical example would be a physician who worries about malpractice lawsuits. Even though typically anybody in a profession like that is typically protected to the degree they need to be protected through the use of insurance. They still worry an awful a lot about protecting their personal assets and one of the best places to get that protection is by having a significant amount of their savings in a tax-qualified plan because of this.

Ed: Another aspect of a dissolution, I mean divorces occur and one way of easing the burden because we knew how. We now have a different tax treatment of the alimony versus what we used to have and no deductions for alimony. That makes it difficult to orchestrate a divorce property distribution versus what you could have done before. That’s gone, but if you have money in the tax qualifier arrangement for example in IRA, splitting it out between spouses is quite easy and makes the otherwise burdensome and very emotional transaction of relatively straightforward.

Chuck: For a lot of married couples in the United States, there’s really two major sources of wealth. One is the residential home and the other is the retirement plans of one or more spouse. If a home is not going to be split, it’s hard to– it happens all the time obviously. It’s always a clunky arrangement to continue to have a home owned by two spouses who have then become divorced. Much simpler if you can put that home in one person’s name and of course having the ability to allocate these other assets. Is the key to being able to do that and still be fair.

Ed: Remember the home is not an investment. Let’s not lose sight of that. Cash is not an investment, but the amount set aside in tax-qualified arrangement really dictate the destiny of the relationship with family, with folks and this has to be contrasted with a non-qualified arrangement. Let’s make sure we’re communicating. The qualified arrangement is one in which there’s a current contribution by either a self-employed individual or a business organization and a deduction for the amount going in. The funds are typically set aside in a trust or in an IRA and they accumulate tax-deferred, not tax-free. Although those distributions given the application of those payroll taxes, and like I just discussed, you’re putting 100,000, it’s really 100,000 versus the then W-2, 100,000 would have left you before the 30X% of your income tax. These other friction costs payroll taxes absorb a good part of that amount being set and being into your checkbook.

Chuck: Right. The most taxed source of income a person can have is income from earnings, W-2 income?

Ed: Absolutely the worst.

Chuck: It’s not only subject to income tax, but it also has all these payroll taxes, so these arrangements, really you’re avoiding, first of all, that tax burden. When you talked about 20% at the beginning of this episode, that was not including just the ordinary income tax? That would apply as well?

Ed: No. It could be 37%.

Chuck: Right. You’re talking about avoiding the income tax and the payroll tax as the money goes in, which effectively provides a boost to the amount going in. The funds that are in the plan grow tax-free. We’ve spent some time in prior episodes talking about friction costs and you avoid those friction costs in the form of taxes on the investments while they’re growing. There’s another friction costs that for some plans, is eliminated altogether for participants and others at least is reduced. Those are the fees and expenses that are associated with the investment account because quite often, what will happen is that an employer who creates a retirement plan will share in some of the fees that are associated with managing the custody of the account and the management of the account. Even in those cases where the employer really has the employees, through their accounts, pay their full share of the fees, those are typically lower fees than what you’re going to find if you just go out as retail investor and try to set up an account. What I’m really talking about here is because the investments are typically in mutual funds, those mutual fund expense ratios, the share classes that go inside retirement plans will quite often not always, but quite often will have lower internal expenses than if you go out and you buy that same mutual fund as an individual investor. All of that basically is reducing the friction costs as the money grows. Then as it comes out, depending on which state you may live in, no state income taxes, and the Obamacare net investment, income tax does not apply to the money coming out. Even though you will ultimately have to pay ordinary income tax on that money, that payroll tax has just been avoided completely, the Obamacare tax has been avoided completely, and perhaps your state income tax as well. It’s a pretty nice deal all around because total taxes lower and some taxes are avoided entirely and the ones that you do have to pay you pay after all the growth has occurred?

Ed: To summarize that, make sure I made myself clear that the taxes that are never paid in connection with a contribution, rounded up to 20%. They’re never paid. Then the let’s assume your round represented 30% marginal tax bracket, those taxes are deferred and you’re getting an investment return on that at 30% one it’s being accumulated and down the road, while you’re paying an income tax at your then-current rate, you’re not having any FICA any FUDA, maybe no state income tax. The issue is you can put away 100% of the contribution and save upfront in effect 50% and end up with paying maybe 30% of the total accumulation when you start accessing those fun.

Chuck: I think that as we go through these conversations about the accumulation phase of the wealth accumulation process, a lot of what we’re talking about really comes down to two categories. One is, what money should you invest? The other is how do you go about investing that money? When you think about these qualified retirement plans, that question about what money should you invest, it seems to me that some of the secrets some of the sometimes well-kept secrets are the best money to invest are either money that belongs to other people, borrowed money, or in the case of these retirement plans is money that you didn’t have to pay tax on before you put it into the investment. At least it certainly looks to me like where I’ve seen people with a relatively modest income, still managed to accumulate fairly substantial nest eggs. It has almost always been in the form of being very aggressive about getting those investments into a retirement plan.

Ed: Recall we talked about one of the preceding webcasts a characteristic of various classes of income. W-2 is the worst, Intermediate is what we’re talking about tax-qualified arrangements and the very best is long term capital gain. Again focusing on why taxes matter while they do and, but most importantly accessible by most wage earners, self-employed or employed by an organization would be the tax-qualified arrangements versus non-qualified, which would be a severance benefit a bonus you receive after you retire in the way of a distribution deductible expense by the part of the organization and you pick it up as income. Now, accumulation potential. Let’s assume that you set aside a tax-qualified arrangement $10,000 a year for each of 40 years. Think of that. At 4%, you’d have 950,000. At 6%, you’d have 1,457,000. At 8%, you have almost 2,600,000. At 10%, you’d have $4.4 million. That’s $10,000 a year. Now, that’s not rocket science, but that gets the issue of putting away the money at an early age and let it grow.

Chuck: I just want to comment about that number, the growth at 6%. One of the rules of thumb that we always come back to is the long-term performance of the equity markets as being between 6.5 and 6.75% above inflation over the long term. This number, this 6% growth really reflects you can think about that as, let’s say, over those at 40-year period. Your investments in this fund, the slightly underperform the long-term performance of equity markets. What you end up with is $1.5 million in today’s dollars. You can say it’s going to be; you’re going to have an actual balance that’s higher than that, but you can think of it as $1.5 million in today’s dollars. What does that mean in terms of living off of that money? Well, another rule of thumb that proves to be pretty consistent across the investment industry is that if you have a pool of investments that you can pull on average, 4% per year, out of that pool of investments on an ongoing basis, for essentially indefinitely. In other words, you can take 4% out of a pool of investments each year, and you can still expect the principal. What’s left in there to be able to grow at the rate of inflation. This is a nice little encapsulation here. That if you set aside $10,000 a year for 40 years, what this means is, just back of the napkin calculations, that you can have retirement income. Again, everything I’m saying we can say we’re expressing it in today’s dollars. Set aside $10,000 a year for 40 years, and what you’ll end up with is an income stream of $60,000 a year, indefinitely.

Ed: Forever?

Chuck: Forever. With the principal, whatever that has grown to and keeping up with inflation being inherited by the next generation. That’s not $60,000 a year as retirement income. Isn’t the thing that’s going to allow you to buy your own private island. But it is going to give you financial security in the sense that you’re not going to starve, you’re not going to lose your housing. Of course, in at least, unless the social safety net completely comes unraveled, that’s not going to be the only source of income for most people during those retirement years. That’s a very significant number for somebody who is just trying to build a nest egg that they should feel gives them some modest security and retirement.

Ed: Get back to Lucy and Charlie Brown. Lucy, in the pumpkin episode where she said, ”Charlie, you’re a blockhead. “The bottom line here is, you’re a blockhead if you don’t set aside as much as you can, as early as you can. Take into account all these friction costs I hate to say that, I hate to characterize all the listeners as the blockhead, but I must say that I’ve avoided blockhead characterizations. Because for whatever reason, I put away as much as I could, as early as I was able to, and which permits Chuck and I, at least speaking for me to do these podcasts. Aside from that, you have access, let’s assume it’s an IRA case in medical emergencies. Or catastrophic illnesses, are issues with family helping others. The point is, don’t be a blockhead and put away as much as you possibly can, as soon as you possibly can.

Chuck: Well, I can say speaking for myself, that the time that I incurred the greatest angst, the greatest financial pain in deferring money into a qualified plan was when I had the very least amount of money to do so. Today I’m the most grateful for having done it at that point in my life. We’re talking about right out of college, when it seemed like just scraping together grocery money was a significant challenge sometimes. Yet, my wife at the time, and I, we made that decision that we were going to maximize the amount that we could put into these retirement plans. That act, just because of the fact that at the time we were young, it’s just that the age really matters. The money we deferred at that point in time, turned out to be the very most important to get into these plans. Later in life, that became easier to make deferrals. I kept up the habit, but ultimately, it’s those early years that really made the difference.

Ed: Deferral of self-gratification. Doing what’s best for you long term in the near term is extremely difficult. On the other hand, the greater the degree of difficulty, the greater the reward. There’s no question about that. We’ll be talking about two very large series of tax-qualified arrangements. Just by way of an overview, we have a defined contribution or an individual account plan. Where you have an account, hopefully, subject to your ability to direct investments, and that amount can grow to $20 million. There’s no constraints on the amount that you can have in that arrangement, defined contribution plan, individual account plan. Having said that, there was a movement years ago and legislation wasn’t acted but the effective date was deferred and finally it was abandoned. Put a constraint or limitation in the amounts that you can accumulate from the date of the enactment going forward that never worked. Then we have a defined benefit plan and thank social security and the defined benefit plan is designed to produce a life annuity beginning at your age 62 a fixed amount per year that generally speaking doesn’t vary. The amount that must be set aside to fund that is a lot of money, but the bottom line, if you have that arrangement, you will not believe the amount of money that can be set aside for you at age 62 in a defined benefit plan. The other problem with both of those is that being self being employed by business organization, they have only a 401K plan. These opportunities are not necessarily all of the available to you, but nonetheless know that the opportunities exist. The magic, if you can be putting away say 25% of your pay every year, your age, 62 or 65 you’re not going to believe the amount of money that’s available to you.

Ed: Well, and if you happen to be a business owner and you’re not putting a plan like this in place for your business, then you’re doing yourself and your employees a huge disservice. I would certainly add that comment.

Chuck: Yes, and the bottom line is you’ve got to give to receive. You’ve got to make sure that the folks that you’re working with, you’re working with them, they’re not working for you. It’s an arrangement that if properly administered the results come back to you in multiples. You’ve got to give in order to receive and giving means setting aside as much funny money for your employees as possible. If you’re self-employed or a business owner, think of that. By the way, there’s only one area that results in a conversion of ordinary income to long-term capital gain and we’ll be talking about that. Not only defined contribution, defined benefit plan, that is the cash balance plan that within the defined benefit plan segment is terrific, but the most terrific arrangement is called an ESOP and we’ll get into that. That’s the only thing that’s better than sliced bread. Okay. See you next time.

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