E91: Reasons to Beware Big Myths of Retirement Taxes

Nate: Many people believe that retirement programs are great tax shelters. However, in this episode, we will discuss the three biggest issues with how retirement programs are taxed and how you can save yourself from overpaying Uncle Sam. She’s Holly and she helps people find financial freedom.

Holly: He’s Nate, he makes sense out of money. This is Dollars and Nonsense. If you follow the herd, you will be slaughtered.

Nate: All right. Well then, here we are in April, tax season for most, a dreaded time for all of us. And it’s at this time, that we start getting tax advice from our accountants, or from the internet, or from just being a member of the sheep that we’re all just kind of going in one direction. Holly, today we want to talk about some issues during this tax season, why people are funding retirement programs because they believe there are certain tax benefits to doing so. But a lot of times, that’s just a mirage that’s hiding the fact that we might be setting ourselves up just actually paying more in tax than we otherwise, should have paid in tax to begin with.

Holly: I agree, Nate. I think a lot of times right now, our accountant say we get a little break. We don’t have to pay taxes until July. Some of us have already paid our taxes. Some of us are going to continue to go ahead and pay them in April right now when they’re due, but this is when the accountant says to us, “Hey, you need to contribute more. You haven’t contributed enough to your retirement program and by contributing more, it’s going to help save you on your taxes.” In fact, that is most of the terminology you’re going to save on your taxes, but that is a myth, Nate, and the reason it’s a myth is because it’s actually not tax savings that you’re… Yeah, maybe you’re saving not paying this year for that money, but you’re actually just deferring that tax to the future of when you will have to pay it.

Nate: Yeah, you’re exactly right. That’s myth number one that if I contribute to my retirement program, I’m going to save money on taxes. I’ve talked to so many people who believe that. I’ll have a client and we’ll be talking and kind of making a strategy and he goes, “Oh yeah. I just met with my accountant and he said I got to contribute $20,000 to my SEP-IRA or max out 401k contributions…” Or whatever it is that he’s talking about, “… because my tax bill is just so high and I want to get it down.” I am a little bit surprised how many people buy into it because always remember; a contribution to a retirement program is not a tax savings mechanism. It’s a tax deferral mechanism. So anytime you contribute to a traditional IRA or a 401k, anytime you contribute to a retirement program that you’re getting a deduction this year, that automatically means that in the future, you’re going to have to claim that money, that income back. It’s not a tax savings thing. It’s a tax deferral.

There’s a big difference between the two. Holly, I think I mentioned to you about this right before we got started, like health savings account or something like that. There is a way to use that to actually save money on taxes because if you contribute to an HSA, many times, you get to deduct that money from taxes this year. Then if you use that for medical expenses, then you don’t actually have to claim it when you pull it out. There’s some real tax savings in there. Having kids and getting a $2,000 child tax credit or whatever, that’s tax savings. There’s things that actually save money on taxes, but contributing to a 401k is not a tax savings maneuver. It’s a tax deferral.

So by not contributing to a 401K or an IRA, sure you would pay more taxes this year, but maybe you’ll pay way more in the future then you should be paying and it would outweigh what you’re paying this year. Maybe you’d rather just use the money. I know a lot of people, they’ll put in $10,000 to their IRAs and say, “It saved me $2,000 in tax.” Yeah, but wouldn’t you rather just pay the $2000 of tax, have $8,000 to use today, put it into a policy and use it every day for the next 30 years and then pull it out later to completely tax free as opposed to hoping that it’s going to make sense in the long run?

Holly: You have to give them more money most of the time than what you would have paid in the tax. You’re tying up that money. You’re using, Nate and I talk about this a lot, but realize even that $10,000, the $2,000 that you saved supposedly, you actually deferred, but the $8,000 you tied up for a week dollars or future dollars that you can’t use today and most of us can’t even use it 10 years from now or 15 years from now, or even if we can, how much is that $8,000 really going to be worth five years from now versus what I could have done with it right now here today? Because we all need money to live on today. We’re going to need it in the future, but you need to live on it today. That’s what we want you to do. We want you to keep that money in motion. When you hear tax savings, you immediately think this is a benefit to me. When in reality, it’s not actually a benefit to you; it’s benefiting everybody else, but you.

Nate: Right. I’ve said this before plenty of times, but it’s remarkable how many people that I run across, they’re essentially living paycheck to paycheck with a retirement program and they’re just contributing because they think it’s the best, but they got car loans and they’re just barely scraping by. They may have $50,000, a hundred thousand or more in retirement programs that they just can’t touch and it’s like they’re living their whole life building up this hope for retirement that doesn’t even produce a lot of value when freedom today is very important. So that may not be in the scope of this podcast, but certainly good a good thing to mention.

So myth number one, issue number one is that retirement programs do not save money on taxes. They defer money and they defer the use of the money to a later date, and when we pull it out in the future, we’re going to pay taxes on that. That kind of leads us into myth number two, Holly, and the second thing that many of us believe that it’s really just not turning out to be true for a lot of people and that is, hey, we’ll all be in a lower tax bracket in the future. So go ahead and contribute as much as you can now while you’re working, because in the future you’re going to be in a lower tax bracket. So when you pull that money out of the retirement program, you’ll end up paying less in taxes. Why is that not panning out the way people had hoped?

Holly: Well, number one, I’m just shaking my head because I think you have to ask yourself one important question, Nate, and that is; do you believe taxes are going to go up or down? Taxes for the majority part, they go up. They increase over time, they don’t decrease over time. So when you hope that you’re going to be in a lower tax bracket, the reality is you’re probably going to be in a higher tax bracket earning less money in order to pay those taxes. I think the other thing is you lose tax benefits as you get older as well, Nate. You don’t get the tax credit and a certain age when your kids are old enough, so you’re not getting those deductions. I think the other thing is that social security comes into play and then if you have social security, which can be taxed as well, is this money that you put into your retirement program.

So I think it’s a huge myth to believe that you’re going to be in a lower tax bracket. We’ve shared the highest tax bracket over the last hundred years and the average tax bracket, but the reality is you will be paid more money. If you answered, “Taxes are going to go down,” you’re wrong. Taxes are only going to go up and you’re going to be in a higher tax bracket. You’re not going to be in a lower tax bracket than what you are here today than in the future.

Nate: Yeah, I guess it’s possible if you just make a lot less money when you’re in retirement than you did while you’re working, but I don’t know a lot of people who that’s their dream like, “Yeah, I want to make a lot less in retirement than I do while I’m working.” As you said, Holly, you could even make less in retirement than what you did while you were working and still be paying more in tax. Because of the issues with losing out on deductions, whether that’s mortgage interest and children at home and different things like that that would offset that and just as well as taxes are probably going to go up. The reason we think that is if you look at the national debt, it’s climbing crazy and then. Here in 2020 with the COVID-19 pandemic and the government is going crazy with trillions and trillions of dollars of extra spending this year alone, who’s going to pay for that?

At some point, I think the budget’s going to be balanced to do that. They’re either going to have to reduce government spending or increase taxes most likely. I feel like neither party is really that interested in reducing government spending by that much. So I think it’s going to be more tax. And you’re stuck. Depending on who gets voted into office near your retirement is going to determine how much you’re going to have to pay in tax on this income. There’s certainly no guarantee that you’re going to be a lower tax bracket in the future, but as Holly mentioned as well, your social security income, whether that’s there or not, we could talk about that too, but-

Holly: We could.

Nate: … if it is there, it’s a very low threshold of income that then creates a taxable social security. If you make like $40,000 of income that’s taxable income, then 85% of your social security income is taxable. So not only are you paying tax on your distributions, but now you’re creating taxation on social security income, but you don’t actually need to pay taxes on if you weren’t having all of this deferred income. If you instead did like a tax free thing, whether that’s a Roth IRA or infinite banking policy or something like that, those distributions are not taxable and they also don’t affect your social security taxation as well. I don’t think that we should all just buy into, “Yeah, let’s go ahead and defer the money to a later date because we know we’re going to meet in a lower tax bracket.”

We’re finding time and time again, that’s just not happening. So we find ourselves at the end of her life having given up the use of our money, deferring the use of that income that we’re making to hopefully, be in a lower tax bracket in the future and then it turns out that we’re not, and it seems like we wasted the use of that money living frugally and suffering, deferring all of this income, deferring all this money into retirement programs to one day realize, “Maybe I didn’t have to do this because I’m in at least the same tax bracket.” Sometimes people are in an even higher tax bracket.

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Holly: When you think about that word, “retirement,” do you really want to live on less than what you were earning? Do you really want to adapt and change that lifestyle and yet that’s really what you’re going to have to do if you really believe you’re going to be in a lower tax bracket. You’re going to have to really live on less and not take the distributions that you really want. I think that that’s what you have to think about. When you go to retire, most of us have become accustomed to a type of lifestyle and to change that lifestyle drastically, things have to change and most of the time, we don’t want to change what we’ve become accustomed to.

Nate: Yeah, you’re right, you’re right. Even if you did live on less than retirement, that doesn’t exactly guarantee you’ll be in a lower tax bracket in the future. It just not worth it to me. It’s not worth it to defer and have the uncertainty, that I might be wasting the access to this money and hope for a tax break may not even be there. In fact, it seems like it’s almost unlikely to be there-

Holly: That it will be. Yeah.

Nate: … how things are going. So that’s been number two. That kind of leads us to the third myth that many of us believe about retirement programs, which is that, “Hey, whenever I die, I’m going to be able to leave this 401K, this IRA to my heirs and it’s going to be a good thing. It’s going to be a valuable thing to leave to them, like a great idea.” One thing that we’ve seen is that whenever you leave an inheritance of a retirement program, a lot of the benefits that a lot of other assets receive, those IRAs and those 401ks, they don’t receive the same benefits.

We’re going to talk a little bit about that, but essentially all of that money that your heirs receive whenever they pull it out, it’s going to be 100% taxable at whatever their income brackets are. Then on top of that, in 2020, they’re even becoming more strict on how quickly people are being forced to pull money out of these IRAs. So is it a good vehicle to leave an inheritance? I don’t know. Certainly not for a tax viewpoint, it’s definitely not.

Holly: Well, think about this. If your kids are earning decent money, just decent and you leave this inheritance to them… Or I’m even going to say a spouse like for me, my spouse, if I had my money honestly in a 401k, then I’m leaving to my spouse, he has no ability honestly to pay that taxation on it because his main resource, and I wouldn’t change it at all, is he is the stay at home dad that is raising and educating our kids. So I’ve just created for him taxation and I’m going to say, Nate, we picked a, let’s say I left him $1 million, he honestly would lose 30% of that or have to use the money more quickly to provide for the family. Today, that million dollars at 30% doesn’t leave much to live on for very long.

Nate: No, it really doesn’t. As I was kind of alluding to, whenever you pass away and you own certain assets, there can actually be a tax benefit, a tax break for your heirs. We were talking about this before the podcast to Holly and that if you own real estate that’s been appreciating or you own even just stocks in a brokerage account or some other asset, many different kinds that have appreciated in value… So let’s say you went out and you bought real estate worth $500,000 and that’s what you paid for it years ago and it’s appreciated and it’s now worth $1 million. If you sell that real estate in your lifetime, you’re going to have to pay tax on the profit that you’ve made, $500,000.

However, whenever you leave those properties or those stocks or whatever the asset is that you own, if it’s not in a retirement program, your heirs, they received what’s called a stepped up basis, which means if you passed away that same million dollars, when your heirs receive it, if they were to sell it the day that you died for $1 million, they would owe no tax because as soon as you died, the basis, that’s a fancy word for saying that’s how much the value is the day I bought it and it’s used to compare to what you sell for, well the basis would have gone up to a million. So they could sell it and owe no tax because the basis was bumped up, a stepped up basis upon their death. But the problem with retirement programs is that it doesn’t matter what the value is whenever you died, or whenever you bought the stocks that are inside the retirement programs or anything like that. All the money is taxable at whatever your beneficiary’s income is when they decide to pull it out. So they don’t get the value of getting a stepped up basis.

They have to pay 100% of whatever they pull from the IRA is taxable. Then on top of that, just this year, there’s been a change in the regulation for… It used to be Holly, if you inherited an IRA from your parents, let’s say, that you actually had your entire lifetime to withdraw it. You can withdraw it over a really long time frame and so you could minimize the tax burden. You could stretch it out. However, now, they’ve really gotten rid of that. You only have 10 years to withdraw all of the money in an IRA or just pay taxes on the full amount at that time. So they’ve scrunched of the time period down, which means that a lot of that is going to go onto your heir’s taxable income in a very short period of time, which probably is bumping them up into higher and higher tax brackets if they’re having to liquidate in 10 years or just pay tax on the full lump sum at one time. That’s going to be a lot of excess taxation.

Even while you’re living, we believe a lot of tax saving myths about retirement programs, but even upon death and leaving it to your heirs, I think there’s going to be a lot of excess taxation being paid. I think the government knows this too. I think they’re a big fan of it. They’re trying to pretend they’re giving you this benefit, but in reality, I think they’re looking greedily at receiving large tax payments compounded because now, your assets are worth a whole bunch of money, a lot more than you put in hopefully. Then you’re paying taxes as you pull that larger number out and give it to the government, a big base. I think they kind of enjoy it. So I don’t know if it’s a great tax system to be honest with you.

Holly: Well, and I think that’s one reason why they implemented even a timeframe. They want the money. Our government does want that taxation. They do want that money. And if they can get it sooner rather than later, they’ll be happy. Or if you wait and you’re hoping that 10 years from now, you’re in a lower tax bracket or something, or whenever you take out the lump sum, the bottom line is, they’re going to get their money one way or the other and instead of having to wait, not just the individual who passed the inheritance to kids or whatnot, and then waiting that person’s lifetime before it’s tax, what they’ve done is just say, “No, we’re going to get our taxes one way or the other and we’ve figured out how to do it.” I think that that’s really important to understand that you might’ve thought, “I’m leaving something very valuable as an inheritance to my family ,” and in actuality, what you’ve done is created an additional burden or additional taxation to them upon your death.

Nate: It goes to show why we believe so heartily in the infinite banking concept because we can avoid a lot of these issues. We’re not having to set money aside that can’t be used for years hoping that we’re in a lower tax bracket later. We’re able to use it today, we’ll use it in the future in retirement, and we know how to use it without paying any tax on it at all that doesn’t impact your social security taxation and then the death benefit passes to your family tax-free at any point, whether it’s late in life or soon. We can avoid a lot of these issues with taxations that most retirement programs are experiencing.

With that being said, Holly as well, we wanted to mention a little bit about retirement programs here in the year 2020. So if you’re listening to this way later and you’re not in 2020 anymore, this may not apply to you as much, but with the COVID-19 pandemic and the government trying to unlock some money for individuals who are affected, there has been some change. The main changes to how they’re going to tax distributions and whether or not they’re going to penalize distributions. So we thought we’d at least give you guys a basic understanding of what’s been changed in case you did think, “Yeah. I wouldn’t mind getting some money out of the retirement program world.” To be honest, this 2020 might be a decent year if that’s been of interest to you.

Holly: It’s of interest too because you do get to avoid a 10% penalty for early distribution or withdrawal from the 401k up to that hundred thousand dollar mark, but also even limited at times where you are limited to what you could withdraw out, they’re allowing you to drop that hundred thousand dollar mark out without that 10%. So I think it’s really important that normally if you were thinking, “Hey, I want to use my retirement money and take it out and put it into some other avenue or vehicle,” and I’m going to promote whole life insurance dividend paying because I just believe in it so much and I think it’s the best option out there, but if you do that, you don’t have to pay that 10% penalty this year. With what’s happened with COVID-19 and your income and stuff, some people are going to have greater losses this year, which will impact the fact that they could take this money out and use it today. Another benefit of it, I’m going to turn it over to Nate. What’s another benefit?

Nate: Well, as you’ve said, being able to avoid some of the 10% penalty for withdrawals up to a certain limit. You want to talk to a financial professional who’s really deals with this. Don’t just take a quick podcast blurb and be like, “Yeah, I understand everything. Make sure that you understand what you’re doing, but being able to take out certain size distributions from your retirement programs without penalty, but also they’re letting you kind of phase the taxation that would normally be owed on a distribution like this over a period of time. I believe it’s three years. If you pulled out $100,000, which I believe is the max distribution that you can take penalty free if you’ve been affected by COVID-19. So you can take that out as long as you qualify and everything and not have a 10% penalty, but on top of that, you’ll be able to spread the income over the year 2020, 2021 and 2022, unless you would rather.

So it makes sense like, “Hey, we can access up to a hundred thousand dollars,” most of us I think should be able to do that without paying a penalty. Then we can even spread the distribution out over a few years if you’d like to, which may mean you can protect yourself from getting into a higher tax bracket for having just $100,000 right on top. But I guess I could also say that if you’re without work or you think this is going to be a very down year for your business, then maybe actually just paying all the tax this year might make sense because your income may be down quite a bit, but either way they, they’re offering that benefit to where you can spread out retirement program distributions.

You can have a no penalty free and also spread out the taxation owed on them over the next three tax seasons. If you are somebody who has some money in retirement program who’s listening to this and really buys into our philosophy on how we see retirement programs and the taxation you’ve been wanting to get out, it does seem like 2020’s a pretty good year to take some of that money out, maybe use it supercharge a infinite banking policy or do something with it that you’ve been wanting to do with it because it seems like the taxation and the penalties being reduced or waived is certainly something to look at.

Holly: This is an opportunity for you to be able to start creating a legacy for your family, as well as creating something that you actually can use to live off of or to benefit you, not just now today, but using those dollars today for living as well as have something in the future to pass on. I’m going to say you pass on that inheritance and that tax-free. I really would hope that you guys are hearing that there’s opportunities out there for you guys right now, today and Nate and I really would love to help you be able to do that and figure out a plan that works for you and your situation.

Nate: Absolutely. Remember, everyone, if you follow the herd, you will get slaughtered.

Holly: For free transcripts and resources, please visit livingwealth.com/e91.