Investing in a Retirement Account is Like Taking Out a Loan

Ever since the FIRE (financial independence/early retirement) movement hit the scene I started to question conventional financial wisdom. 

Most of the advice preached was re-purposed from generations past. A penny saved is a penny earned turned into a variety of frugal anecdotes. You can’t read Proverbs (from the Bible) and not recognize the many similarities in advice. Sound money principles have ancient roots.

For a time the FIRE community welcomed me as one of their own before I stepped back a bit to cut my own path. (No sense in another voice calling out the same message.) I’m still part of the community, but gave myself permission to question the dictums of said community. The hope was to build a bridge from where we are to a higher level.

It also became clear my net worth was near the top of the demographic. This bothered me and caused me to conclude something was wrong.  How could a backwoods farm boy with nothing more than a high school education, a few college courses and a full personal library do better than virtually all within a community so dedicated to wealth?

I don’t trust luck to carry me that far. It had to be something else.

Then I started reading what was published in the tax field and felt a great disturbance in the force. While the advice was fundamentally sound, it also lacked in effectiveness if brought to task. All too often blogs were using IRS publications as their authority. (The IRS is NOT a tax authority; they are a bill collector.) If people followed this advice and the IRS ever challenged (likely with so many people tempting fate) there was a real risk of loss. (If you go to Tax Court and say you used an IRS publication as your substantial authority you lose automatically even of you a right! IRS publications have zero authority in Tax Court.)

Sometimes the math was fuzzy. A blogger might claim a certain level of frugality when it didn’t add up. Some claimed a level of wealth that also didn’t add up. Either the rules of mathematics were suspended or someone was trying to pull the wool over their reader’s eyes.

The biggest area of concern involved retirement accounts. The mantra of filling retirement accounts to the hilt for long periods of time has some obvious issues. 

Some retirement account problems are less apparent. Everyone keeps saying this is the best thing since sliced bread. But is it? 

So I started running some numbers and it wasn’t as clear as most are led to believe. There was something fundamentally wrong with the advice.

 

Numbers Game

The issue is with traditional retirement accounts (IRA, 401(k), 457, 403(b), Keogh, profit-sharing and cash balance plans); Roth type retirement plans don’t have this issue.

Roth style retirement plans don’t get an up-front deduction, but grow tax-free. Most financial blogs consider this the best animal in the yard. I agree.

A close cousin — if you qualify for it — is the health savings account where you get a deduction and tax-free growth, to be used for qualified medical expenses. The biggest drawback of the HSA is the amount you can invest annually is relatively small. 

Roth retirement plans are limited in many cases based on income on if the employer has the option in their 401(k) . The maximum Roth IRA contribution is also relatively small. (Exact limits are excluded from this post so changes in the limit don’t distract from the evergreen content.)

The mega-backdoor Roth (a favorite of the FIRE community) allows for sizable Roth contributions with one caveat: it’s probably illegal (according to the IRS). The IRS hasn’t attacked the mega-backdoor Roth because there is no current revenue to be raised by taking such action; Roth investments are not deductible.

However, once these accounts grow in size the IRS could come back and disallow the tax-free advantage, plus interest and penalties. If the IRS has a kind heart (ahem) they could forgo the excess contribution issues which would certainly mean penalties several hundred percent of the entire investment. You decide what course you wish to take. 

The safest retirement plan route means traditional retirement plan investments after you maximized your Roth contributions. Or is it?

 

Loan Document

Traditional retirement plan contributions come with a loan attached to it with a variable rate of interest, to be determined at a later date by the tax code and your income level.

All you debt-free warriors should feel a bit nervous at this point. Just as a mortgage-free home still has loan-like obligations (property taxes, insurance, maintenance), a traditional retirement account has an unannounced interest-like expense and it is a big one.

And this is what disturbed me so much that I had to publish a post on it. 

We all know that traditional retirement accounts get a tax deduction at your ordinary tax rate up to the retirement plan contribution limits. We should also know that these accounts grow tax-deferred and that all distributions are taxed at ordinary rates.

This is a real problem if your goal is to maximize your net worth. In the early years the tax benefit makes it seem like it is the best deal on the planet. But as time passes the math tells a darker tale.

Let’s start with a simple example to get a fundamental understanding of this matter:

Joe contributes $10,000 to his t401(k). This is subtracted from his income on the W-2 and never reaches his tax return. His tax bracket is 30%.

We will disregard actual tax brackets as they change over time and we are more interested in a workable formula for determining the best course currently and for future readers as well.

The good news is Joe saved $3,000 on his taxes this year. However, in 40 years, when Joe retires, he discovers his investment in a broad-based index fund performed as index funds have over long periods in the past: around 7% per year on average. Joe is a very happy man! He now has $149,744.58. 

If Joe were to take the entire amount in one year it would be a fairly large tax. However, Joe decides to take the money out over a number of years. As a result his ordinary tax rate is only 15%. (We will disregard taxes on Social Security benefits and other similar issues to make calculations easier.)

Joe now has a tax bill of $22,462. (Numbers are rounded.) That is $19,462 more in additional tax! Call the 19 grand a tax or anything else you want, but it looks like interest on the $3,000 to this accountant.

Even though Joe saw his tax rate decline by half in retirement he still saw his tax bill increase over 700%. His interest rate would be slightly less than 5.2% annualized in this situation assuming Joe never saw his account value increase after he started taking distributions, an unlikely event.

 

Early Payments

If I approached you and said I would borrow you $20,000 at 5.2% would you take it? Unless you have bad credit that is a high interest rate, especially since it in not deductible. Worse, you can’t make early payments to get out of the deal! You can’t jump ship until you are at least 59 1/2 years old. And if you are stubborn I’ll kick you overboard at 70 1/2. 

The good news is I’m a nice guy and will not do that to you. On the other hand, Congress has passed laws the IRS carries out doing just that.

And we haven’t seen the worst part yet! Retirement plan distribution included in income can cause more of your Social Security benefits to be taxed and can also increase the premium you pay for Medicare once you reach age 65.

A small tax deduction today can do real damage in the future. This is why I say I want multiple tax benefits before I get excited about a tax deduction. 

All this assumes your tax bracket drops when you retire. Considering the massive government fiscal deficits during a strong economy, it seems to this accountant taxes will go up in the future. And if your income remains high in retirement your tax bracket will also be higher.

Consider this: If Joe had a 30% ordinary tax rate on his retirement plan distributions his taxes would have climbed to $44,923, a full 7% annualized rate. For people with good credit this is a massive interest rate and almost nobody is thinking about this.

 

The Cold Equations

Joe’s example is unfair. First, Joe will put a lot more into his retirement plan over his lifetime, therefore, the damage will be much larger.

Second, retirement plan distributions happen over a number of years. While this might sound like a solution to the problem, it actually makes it worse as the investments continue to grow over time.

Third, smaller account balances experience the same issue only with smaller numbers and that tax rates might be lower due to the lower income level.

Fourth, early retirement does not solve the problem. Yes, you can take a limited amount of money from a traditional retirement account before age 59 1/2 without penalty under Section 72(t). This only reduces the amount of time the money has to grow; it doesn’t resolve the issue.

No matter how you cut it, traditional retirement accounts are best viewed as loans from the government, due in retirement. If you don’t pay the piper, your beneficiaries will.

 

 

Alternatives

Your experience will differ from that of others. You can use the simple example above to determine your implied interest rate assessed as tax in the future. You may discover this isn’t an issue for you. Or, you might need a moment for reflective prayer.

We saw that greed for a current tax deduction produces a 5%+ interest rate loan from the government, payable in retirement. So, what alternatives are there?

The best comparison is doing nothing at all (investing in a non-qualified account). You still invest in the same index fund. Dividends and capital gains are taxed at the lower long-term capital gains (LTCG) tax rate (15% or less for most taxpayers) instead of ordinary rates later (up to 37% federal, plus state income taxes). 

Since the money is outside a traditional retirement account you don’t have to worry about early distributions or required minimum distributions. And if you die your beneficiaries get a step-up in basis the retirement accounts don’t get. Gains on these investments are also taxed at the lower LTCG rate. 

 

Matching

I can hear the complaint already: What if my employer matches?

A valid argument. We’ll go back to Joe again and assume his employer matched his contribution 100%.

Joe invested $10,000 of his own money and his employer matched his retirement plan contribution with another $10,000. 

Joe still gets a deduction worth $3,000 for his contribution. The employer’s match is free money and not taxed until Joe takes the money out.

In total, Joe has $20,000 invested in his retirement account. His account grows to $299,489 in 40 years. The tax on this at a 15% tax rate is: $44,923. 

The initial tax benefit to Joe is $3,000, plus $10,000 from his employer, for a total of $13,000. The implied interest rate in this situation is around 3.15%.

The lesson of this part of the story is that using your employer’s retirement plan up to the match maximum is still a good idea for most. After hitting the matching maximum you might be better served putting the rest into a non-qualified account, however.

 

Smart readers will also be quick to point out the extra tax savings means you have more to invest which mitigates any of the extra taxes owed in the future. This would be true if people actually did that.

When was the last time you invested your tax savings from a traditional retirement account investment? Where did you invest it? Uh-huh. Thought so. You spend the tax savings as most do.

(If you are one of the few who actually pull the tax savings from the family budget and invest it in a non-qualified account my hat comes off to you. You still need to run the numbers to verify the best course of action.)

 

Facts and Circumstances

You can’t read tax law for more than a few minutes before running across the words “facts and circumstances”. And this situation is no different.

I gave you the tools to build a working plan based on your facts and circumstances. Use a future value calculator to determine the interest rate the tax code is forcing you to pay if you use traditional retirement accounts. 

Employer matching is a real benefit that is diminished by the tax code after very long periods of time. (I would focus on the employer match closely as real value can be found there.)

After the employer match and available Roth retirement plan contributions allowed are exhausted you might find non-qualified accounts the best course of action, for you. 

The important thing is that you are reading this. That means you are more likely to run your numbers for the best options, for you. 

There are a lot of factors at play. Index funds still kick out dividends and some capital gains which are currently taxed. This slightly reduced the implied interest rate of the traditional retirement plan if you are prone to investing tax savings. It also assumes you keep your fingers off the pile until retirement. 

The one thing to remember is that deferred taxes frequently come with an implied interest rate paid as a higher future tax.

This is the kind of stuff I think about in the dark of the night. It might also be the prime reason I top the net worth list at Rockstar Finance.

 

 

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