E31: You Need to Know the Hoax of Tax-Deferred Programs

In this episode, we question the notion that you save money using tax-deferred programs. Typically, this is sold through funding your IRA or your 401K. We’ll also clarify what we believe a real tax-savings is.

We hear a lot from our clients come this time of the year saying, “Hey, I normally fund my IRA or my 401K because my tax bill is so high. The common thought is that you will save money on taxes by funding them.

But we have a beef with this. It doesn’t actually save money on taxes. It’s a smoking mirrors type of thing.

What people don’t really understand is that on these deferred programs you’re not actually saving any money on taxes. They’re not called the tax savings programs. However, they are called tax-deferred programs.

We discuss in more detail in this episode…

The Tax-Saving Hoax of Tax-Deferred Programs Topics Discussed:

  • Doing the math
  • Tax-savings vs. tax-deferred
  • The long-term outlook on tax rates
  • IRAs and 401Ks
  • The impact of inflation
  • Opportunity costs
  • Leveraging whole life insurance policies

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Podcast transcript for episode 31:  Hoax of Tax-Deferred Programs

Nate: In this episode, we will question the notion that you save money on taxes by funding your IRA or your 401K, and we’ll try to clarify what we believe a real tax-savings is. 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: Okay, Holly, well it’s good to be back, and we are at the end of year. You and I, as we discussed before the podcast, hear a lot from our clients come this time of the year saying, “Hey, I normally fund my IRA or my 401K because my tax bill is so high. I try to fund this so I can save money on taxes,” something that we hear said quite a bit. This idea of if I fund my IRA, I will save money on taxes. You and I have a little bit of a beef with that, that notion there that’s saying, I would say it doesn’t actually save money on taxes. It’s kind of a smoking mirrors type of thing. I was curious what your thoughts are on that idea of, “Hey, if I fund my IRA or my 401K, then I’ll save money on taxes”?

Holly: I think it goes back to what we were talking about having your mindset I’m going to save this money on my taxes, so you have a dollar amount. I’m going to use $10,000 that we talked about. Hey, I’m going to put $10,000 into my IRA or my 401K in order to save on taxes. Actually, what you ended up doing is maybe only saving $2,500 on taxes but it cost you $10,000. Really in the reality of it, you had to spend money in order to save money and that to me doesn’t necessarily mean you’re saving money on taxes. Wouldn’t you rather have just paid the $2,500 in taxes and then had the $7,500 to use?

Nate: Exactly. That’s my big issue is what people don’t really understand is that on these deferred programs, first off, period, you’re not actually saving any money on taxes in the grand scheme of things. It’s not called the tax savings programs. It’s called a tax-deferred program. We know this, anytime we deposit money into the programs, you’re not just deferring your tax; it’s more like you’re deferring your income. If you didn’t fund $10,000 into your 401K through the year, you would have had a higher income, which means you’ll pay higher tax, but you’ll also have more money to work with. So all you’ve done is you’ve stocked money that we can’t touch without a steep penalty to touch before your retirement age, 60 practically. But even on top of that, whenever you pull all the money out, even the $10,000 that you put in is going to be taxable at your personal income tax rate.

If you had just not even used the IRA to fund it, you will be taxed at a long-term capital gains rate or something like that, which is a lot of times is less than people’s income tax rate. It just not only deferring your tax, it’s deferring your income, your use of the money. So it’s essentially like spending $10,000 to save $2,500, and it doesn’t really save money on taxes. You just are essentially telling everybody that we are going to kick the can down the road. I don’t want to use the money right now for myself and do anything. I have nothing, no ideas that I could use the money with. I think that’s the biggest issue with the tax-deferred programs.

Holly: I think also, Nate, it’s what you touched on that we view tax-deferred as tax savings, or not having to pay those taxes. But it means that it’s deferred for a later date. It doesn’t mean you get out of paying that. If we actually truly understood what a tax-deferred program was, we’d never put our money into it because who wants to put money into something year after year, after year, and it’s your money that you put in, but you get penalized to use it? That’s like letting somebody have your money for 20 years and never touching it, and saying, “Here, you spend my money, and you make money off my money. If I use it, I’ll just pay a penalty.” I mean, we would never pay a penalty to use our own money. We would never charge ourselves for money we saved. And if we took it out before we’re 59 1/2, oh no, now I’m going to give myself a penalty? We wouldn’t do that.

That’s just not realistic yet that’s what we’re doing because it’s tax-deferred. We hear tax-deferred and immediately think tax savings. If you realize you’re actually not saving anything, you’re actually giving more money over to somebody else to spend and use while you think you’re saving money. It’s wrong because just ask yourself, you think right now you might be in a lower tax bracket, but you probably are going to be in a higher tax bracket the more money you make, the longer you live, because you have less deductions. And taxes traditionally go up. They don’t go down. I might be in a 20% tax bracket today, but 10 years from now, that 20% tax bracket, or 30 years from now, isn’t going to be 20% anymore. It’s probably going to be 25%, 30%, 35%.

Nate: You have a little bit of scope into the future with the country’s debt going like it is, with Social Security being completely bankrupt or at least will be very soon. These things we know are happening. For people to think that tax rates are going to go down over a long period of time … I would hope they do. I hope I’m wrong in this. We all would like to pay lower tax rates for the most part. But the issue is it actually going to be sustainable that people reduce taxes. It is possible with the tax thinking the way it is, especially more on the conservative side, instead of the liberal side, which is, “Hey, if we reduce tax rates, we can increase tax revenue.” I agree with that. I just don’t know if it’s actually, it very rarely happens, and when it does, it’s like a pendulum. Whoever is in office changes it and does this and does that.

It’d be very difficult, no matter who you are, Republican or Democrat, to reduce taxes and a lot of these. Most likely, taxes are going to go down. We also, just due to inflation, people’s incomes are going to go up. And what we’re hoping is that the tax rates follow the inflation rate, which there’s no guarantee that they will, just to begin with.

Holly: Nate, the last time taxes were reduced, where we had the federal income taxes lowered, was when Ronald Reagan was president of the United States. I don’t even know if you were born then.

Nate: No. I certainly wasn’t paying taxes then.

Holly: Definitely weren’t paying taxes. But if we think about that, we’re talking about a major amount of time that’s the last time that something ever actually happened where taxes were lowered for us as individuals. And so I would hope that they would get lower, but realistically, I don’t see that happening, because it hasn’t happened in so long of a time. The viewpoint is we got to keep raising taxes in order to pay for social security and get out of debt and all these other things. Yet what we don’t see is that that’s eroding our wealth and then of itself. When you put money into the tax-deferred program, you truly are eroding your wealth just due to the time and inflation like Nate said.

Do you want to give them a realistic example, Nate?

Nate: With the inflation issue as we know, we’re putting in these dollars today that we know we can’t touch. We know we’re not going to be able to touch them in an IRA until we’re 60, or in a 401K until you retire. I don’t know if a lot of people know this that just because you hit 60 or 59 1/2 with the 401K doesn’t mean they’ll let you have your money. Most of the time, not every time. Most of the time, you have to actually not be working at that job. You have to really retire or leave jobs and do something to get money from the 401K. You know it’s going to be down the road one way or another that you’re going to be able to touch it.

Every single time you put money into a place where you can’t touch it, you’re automatically guaranteeing yourself that the dollars what they get back, are not going to be same dollars that we put in. No matter what your return is over the timeframe, you might as well just chop off at least 3% off the top of that return, because the dollars are not worth what you could have bought 30 years ago, and if you had been able to control the money. Inflation is just guaranteed to wreak havoc on your money. And then also, because you deferred the tax, it’s like paying as we’ve talked about before, paying taxes on the seed versus the harvest. That mentality where if you go out and use, and you plant some seeds or you plant some seeds of corn, you plant one seed, you might get 10 years of corn. You know what I’m saying? Would you rather pay taxes on the small amount, which is the seeds or the larger amount, which is the harvest?

Your inflation, the fact that hopefully you’re beating inflation with your money, but you’ll actually have this huge pile of money that you have to pay tax on this big chunk instead of the smaller contributions that you made throughout the time. Definitely some issues with the whole you being on a lower tax bracket. You may be. I can’t guarantee that you won’t be, but it’s just why would you take the risk of locking up money for a potential benefit that may not actually be there, when it would be such as more simple life to take control of the money yourself and use it right now, instead of waiting 30 years to use it.

Holly: And we’re going to take a quick break from our sponsors. When we come back, we’re going to talk about what is the benefits of using a program that saves on taxes, that truly is tax-saving because there may be isn’t a tax associated with it.

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Nate: All right, welcome back. We’re going to move in to a new area of what I think saving money on taxes is. I wanted to make one more thing. It just popped in my head, by the way, Holly, which was on the kind of what we’ve ended on before the break, which was a lot of people don’t really understand most assets that you buy are tax-deferred assets to a certain extent. There’s nothing fancy about the retirement program except for the deferral of the income. What I mean by that is let’s say we go and we buy a stock, Holly, and we put $10,000 into the stock when we purchased the stock.

No matter how much the stock grows by, you’re not going to owe any taxes until you sell it, given that it could pay dividends and things. I’m just talking about the appreciation. That’s only when we talk about more comparing these type of things as appreciation. You can go by the same exact stock that you could have bought in your retirement program, your tax-deferred program, or you could just went out and bought it just on the stock market, no program used whatsoever. Then you can sell it whenever you want with no penalty, and you only pay taxes on the gains that you had inside. So if it grew to $50,000, you’d pay long-term capital gains tax on $40,000.

Whereas, if you’d put that same money, maybe you could put 12,500 into a retirement program instead of just 10, because you’re able to save, reduced your tax for that one year and defer it. That may had not grown to 50. It may grow to 60. But now if you pull that money out down the road, both of them didn’t have to pay taxes as the money grew. You just have to pay tax when it’s sold. One of them had to pay tax on a smaller amount just to profits, and at the long-term capital gains rate. The other guy had to pay taxes on the entire distribution, because remember, the 10 grand was not real tax savings that you put into it. It was just deferred income. When he pulls it out, he has to pay taxes. Hopefully, it earn more money because he put a little extra into it of course. But he has to pay full taxes on the entire amount, plus it’s going to be at his income tax rates. Income tax rates are much higher typically than the long- term capital gain rates.

The question is in the grand scheme things, would it maybe even be better not even to use it and still buy the assets you want to buy?

Here is the big thing as we’ve been talking, Holly, is I don’t see tax-deferred programs over a lifetime as a real tax savings. It’s kind of a smoke and mirrors type of program where they say your accountant says, “If you put this money, we can reduce your tax bill.” That’s true. This year, you can reduce your tax bill. But is your life over at the end of this year? Life goes on. I want to eliminate taxes and reduce taxes over in the grand scheme of things, not just in this one year. That’s the problem. It’s very shortsighted all the time.

Holly: I think too, Nate, the problem too is that we don’t truly realize that when we’re putting our money into these tax-deferred programs, the consequences of our actions that you mean, “Really? I can’t touch that money without being penalized? You mean I have to be retired to take the money? Oh, I can’t take it all at once? But I thought I was going to be in a lower tax bracket. But I thought that this was going to help me.” All these other things that you don’t realize until it’s too late, because we basically buy into. We follow the herd, what we talk about. We buy into everybody else is doing it. Everybody else is putting it into this program, so I should do that too. We’ve got to get out of the mentality of just because everybody else is doing it doesn’t make it a good thing, or a great program. It’s just because they might not know any better other than to do that as well.

Now, I say save the money. Save it yourself, because at least it’s your money and you will have access to it when you want to use it. There’s other ways, Nate, that we’ve said you can still use your money, make those investments, have retirement, but it’s not tax-deferred. It’s actually going to benefit you because you’re going to keep your money in motion.

What’s one of those ways we can do that, Nate?

Nate: First off, when we talk about reducing your taxes, a lot of times, you can reduce your taxes by being in business. As Holly and I know, one of the first things that let’s say you’re actually looking to reduce, not defer, but reduce taxes is to think how you can serve people and start a business. Because suddenly, once you start a business and start producing a little bit of revenue, that business can do things that actually reduce your taxes, period, on what you’re already spending. As we know in our country today, if you have a corporation, it has to have a board of directors meeting at least once a year; required to have a board of directors meeting. What’s not required is where the board of directors meeting is held.

You can take your family to Hawaii and have your board of directors meeting in Hawaii. If you are going to go on a vacation anyway, you’ve just turned something that you normally would have spent money on in the first place, and you’re able to write it off. That’s a tax reduction that year that’s not having to defer money or something you’re already going to spend. Same thing with medical expenses and car payments and all of the things that businesses can do.

First off, I’d say one of the ways to reduce taxes is to figure out a way to get into business. Network marketing being a decent business that anybody can get into without having a lot of startup capital. Now, I’m not saying one way or the other, in network marketing some is great, some is not. I’m not trying to get into that. I’m just simply saying that the opportunities are out there that anybody who can start working or start throwing business doing something and have an entity that they run some money through to actually make expenses. That’s one of the things that first popped into my mind of something people can do now that doesn’t lock up any money that they can start reducing their taxes.

Holly: I was going to say taking that money you’re saving and using it for investments like we’ve talked about, but first putting it into a mutual funded whole life insurance company, policy. The reason why is just because that money is going to grow tax-free for you. For me it’s, “Hey, you want to do this investment? Hey, you want to keep your money in motion? You want control of it? Well, go in and put it into a life insurance policy that you’re going to get guaranteed tax-free growth. That’s key is when that growth on your money is tax-free, so that you can go use it and you can make an investment.

Yes, let’s say you went and bought stocks like Nate said. You went and bought those stocks and it grew by $40,000. You took 10 in. You do have to pay the tax on that $40,000. But the money that you put into that life insurance policy never left that life insurance policy, continue to grow tax-free. So that’s a benefit to you that it is growing tax-free over and over and over again, year after year, and yet … I mean, I would even say it’s even better to take your money and put it in a savings account, heaven forbid. But even a low savings account, where there’s still some tax on it, but you still have access to your money. You have access to use it and to decide how you’re going to use it, when you’re going to use it. And you’re not going to get penalized for using that money. You’re actually going to be able to use it today.

I mean, we have been taught to amass great amounts of wealth and put it in the bank, or put it in our retirement program, and let those financial institutions use it. I don’t think any of us would disagree that we have only lost money when we gave it to somebody else, and that we need to be more confident in how our money works and really understand how we can control that money.

Nate: Yeah, absolutely. Yeah, definitely using a policy, as we talked about before, is a great way. As you even mentioned, what’s really cool, Holly, and it’s getting a little bit more into the advance concepts on using policies and the infinite banking concept, when we’re talking about tax savings, using a policy to make investments can reduce your taxes and provide tax savings that retirement programs can’t even offer. Just as Holly said, let’s say we went out and we took out money, we bought an asset with it. We made an investment, and we borrowed the money from our policy to do so. Well because we used our policy loan for investment or business purpose, then we get to write off the interest that we pay back to the policy. But the growth of the policy tax-free over a period of time is going to recapture all the interest we paid, plus make a profit above and beyond. As we showed time and time again in the examples that we share with people.

Not only do we get to write it off on one side, we get tax-free growth on the other side. We can reduce people’s taxes and have the money do multiple jobs. People want to know … Holly, we talk about keeping money in motion. That’s really what we mean. It’s trying to find ways to stretch your dollar to have it do multiple jobs. You’ve got money in the policy that has growth, that has a death benefit, that’s totally tax-free. It’s doing three jobs right there. It’s growing, it has liquid cash, and it has a death benefit. If I can borrow against that and buy a rental property or something like that, that’s going to appreciate and produce rental income. And all the money that flows back in as interest to my policy, I can get a tax deduction for. I got my money doing like six jobs.

Whereas, the retirement program is just doing the one job. I guess you can call it two. It’s in a mutual fund, and it reduced your tax liability this year. You have maybe two. That’s what we talk about when we say keep money in motion is try to use it as many times as you can to produce benefit.

Holly: Yeah. And Nate, with that, that money in motion, when your money is in a retirement program, you have no control over it. It’s not really doing any job for you. It’s there for long-term or in the future. But what we have mistaken is that a dollar is the same as numbers. My dad says it’s a lot. But basically, if we have amassed $10,000, we think of that as 10,000, but that same $10,000 20 years from now, will not buy nearly what it bought today. That’s where we are mistaken. Financial institutions have made us believe that that dollar today is the same dollar in the future, and it’s not. Really, that money in motion is you controlling your money. You making it work for you versus giving it to the financial institutions.

When you put it in a tax-deferred program, you’ve lost the money, unless you want to pay a penalty to use it, and you don’t have control of how it’s used or spent. Those financial institutions are making money off your money while it’s just sitting there for you. We would never ever just let something sit. I mean, we just wouldn’t do that. We wouldn’t buy a loaf of bread and put it in a freezer and wait to eat it for a year or two years. We wouldn’t buy a car. We don’t want stuff to sit. So money in motion is you controlling it doing not just one, two, three, four, five, six jobs. It becomes infinite in the jobs that it can do for you, and how it can produce tax-free growth, as well as give you a lifestyle that is just as good if not better than the retirement program.

One thing I’ll say about the retirement program, it has x amount of dollars. At least with the life insurance program like Nate said, in the policy, you have cash and you have death benefit. That death benefit is normally greater than the cash that you’ve put in. It should be greater than the cash you’ve put in, and that’s a beautiful thing that you get both. You get to use your money, but it’s working as death benefit and cash.

Nate: Yeah. That’s just the key with it. I just cringe a little bit when I hear people say, to kind of wrap this up, should I put money into this or my accountant said I need to put money in to save money on taxes. Once again, it’s not a real tax savings. It’s not a tax deduction. It’s a tax deferral. You’re giving up the use of the money and you’re locking it into a government-sponsored program in order to not pay taxes on the income. The reason they allow you to not pay taxes on the income is because you are deferring not only the tax, but you’re deferring the use of the income.

Whenever you look at the tax rates and the long-term capital gains rate and just how would things work, the benefit that it’s touted is really pretty much not there. We’d rather try to find ways as we talked about to reduce taxes in business or how you construct your investments and lower taxes without having to lock money up, and give up control of it.

I would tell you, if you’re listening to this, understand that I’m not saying it’s always bad to use a tax- deferred program just because I don’t like making blanket statements. But am I going to use one? No. Is Holly going to use one? No. What I am saying is that at least understand the truth. Stop saying I’m going to save money on taxes. All you’re doing is pushing your income to a later date and then going to pay taxes on it, then you’re kind of hoping you’re in a lower tax bracket. The question is, are you really going to be? Did it make sense for that potentially small benefit to give up control of your money for a long period of time? Does it even make sense to do that?

That’s what I had to say, Holly, to wrap things up. Anything on your end?

Holly: I just want to say we need to honestly ask ourselves over the time that that money is in this tax-deferred program. You need to ask yourself, what percentage of that is being eroded just by the time, the non- access to it, just by inflation. Nate said 3%. That’s pretty conservative in my opinion. But even if 3% of that money is eroded over time, you just gave that up. Honestly, look at would I really want to do this if I understood that tax-deferred isn’t tax-free, and it’s not a tax savings; it’s just a deferral.

Nate: Exactly. This has been fun and come up at the end of the year. It’s always fun to think of ideas to save taxes. But just putting money into a tax-deferred program is kind of let the nickel hide the dime in reality of giving up 10 grand to get 2,500 back or something like that. It doesn’t always make sense to do that way even if your accountant loves it. His job is to help you lower your tax bill this year, which I applaud him for doing that. But in reality, once again, many times, if you follow the herd, you will get slaughtered.

Holly: For free transcripts and resources, please visit livingwealth.com/e31.