E141: Beware these Huge Tax Planning Pitfalls and What You Need Do Instead

In this episode, we discuss tax planning pitfalls and the main misconception about tax planning using qualified retirement programs. We also explain why it is one of our biggest pet peeves when meeting with clients or accountants.

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Topics Discussed:

  • The biggest misconception about tax-qualified programs
  • What accounts get wrong or confuse clients about when it comes to tax planning pitfalls
  • How to determine when a tax deduction is actually a tax deferral, and why that matters
  • The opportunity loss of putting your money in “tax jail”
  • The mirage effect of tax deferral products and concepts
  • Critically thinking about how future tax rates will impact your retirement savings
  • How these tax planning pitfalls impact business owners

Tax Planning Pitfalls: Episode Resources

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Episode 141: Tax Planning Pitfalls

Nate: In this episode, we discuss the main misconception when it comes to tax planning using qualified retirement programs, and how it’s one of our biggest pet peeves when meeting with clients or accountants. 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, today we’re launching an episode. It’s going to be right in the heart. We’re near the end of tax season so it’s on everybody’s mind. And it’s around this time of year that we get comments maybe from our clients or from other listeners who have met with their accountant, they’re trying to figure out what to do. Many of them already owning a policy and practicing infinite banking. And so, they’ve bought into our philosophy on how money works, but then they go meet with their accountant, and still the accountant will say some things that make them wonder, “Should I be doing infinite banking or not?”

Maybe not that far, but they would essentially say, “Maybe I should take this guy’s advice.” One of the reasons is we would call it a pet peeve is that sometimes what they say is not actually true. So I think that’s where we’re going to dive in here. The biggest misconception around tax qualified programs that people always hear, especially when it comes time for tax season and really why it’s a misconception. Then what that type of thinking, if we start to believe it, how it can mess us up in the future really. So Holly, what’s a big pet peeve that we have when talking to an accountant about tax qualified retirement programs?

Holly: I think the biggest pet peeve either one of us have, Nate, is when they’re like, “You get a tax deduction,” and the word is deduction, by taking your money and putting it into a retirement program. They’re like, “It’ll save you money. This is a tax deduction.” It’s not a tax deduction.

Nate: They pitch it as a tax savings device. Here’s how they pitch it, Holly. They’ll say, “Okay, we’re coming up on April 15th. You’ve got until April 15th to make some contributions.” So this 401(k), IRA, self-directed, SAP, whatever it is, they’ll come to you and they’ll say, “Okay, here’s your tax bill,” let’s say it’s $10,000, “here’s your tax bill if you don’t contribute to this plan and here’s your tax bill if you do. You only owe $8,000.” I mean, whatever, I’m just making numbers up. So they’ll say, “Okay, by contributing to this program, here’s how we can lower your tax bill this year.” And so, they pitch it as a tax savings program.

But the problem is it’s actually not a tax savings. It’s only a tax deduction in and of itself. It’s a tax deferral. And so, what you’re doing when you contribute to a qualified retirement program, which would be like your traditional IRAs, your 401(k)s, you are setting income aside and you’re putting it in jail. I mean, this is what’s happening.

I don’t mean to just sound horrible per se. I’m just saying, that’s what we’re doing. So we say, “Okay, uncle Sam, I want to pay less taxes now so I’m going to take $10,000 of income that I earned, and I’m going to put it over here in income jail. You have agreed that since I put it in income jail, I do not have to be taxed on it right now and you’re going to allow me to leave it in income jail until a future date that you control, essentially based on my age, but you can write the rules on it and I’m willing to take that risk, I guess. And so, I’m going to put this $10,000 over here and hopefully it grows and earns some value out sitting there.” But when I come back to get it later, I’m going to pay taxes on it at whatever the income tax brackets are at that time.

And so, the problem with considering it as a tax savings device, it is actually an income deferral. It’s saying, “Okay, I don’t want this income today. I’m going to put it in income jail and I want to be able to take income in the future when I retire. I prefer to pay taxes then.” If you go through all of that, if your accountant brings that up and you say, “Okay, yes, that sounds great to me. I want to do that,” then that’s great. I’m just saying it needs to stop being treated and pitched as a tax savings device. It’s not a tax savings.

If you go out, Holly, if you were to go buy a rental property or some sort of real estate, you got some depreciation, that actually feels like real tax deductions that we don’t have to claim back unless we sell the property. But then, there’s the 1031 exchange situation. There’s actually legitimate ways to not ever pay tax on money or there’s things like a policy that’s truly tax-free in nature that we can draw from it tax- free, but the tax deferral systems need to stop getting lumped into the legitimate ways to do that. At least, that’s my opinion.

Holly: You have to consider, Nate, it’s jail. You’re giving this money to a program that you can’t touch for a set period of time, and you don’t have access to use your own money unless you want to pay a penalty to use that money. That’s the other problem I have with it. Is that it didn’t help you deduct taxes, you gave strong dollars away today, and you’re going to exchange them in the future for whatever it buys. But I’ll tell you it’ll be a lot less. And oh, if I do need that money for any reason whatsoever, I’m going to have to pay a penalty to the government to use my own money that I put into my own program. It makes a whole lot of sense.

Nate: Yeah, they’re so nice. And so, the only time that it really does help people is if you can defer the money into the future and be pretty sure that you’re going to be in a lower tax bracket when you actually go to withdraw it. That’s a legitimate question though, that needs to be asked. You talk to most people and they’re very concerned about what tax rates they’re going to be 15 or 20 years down the road. You take a look at the debt we have as a country, The fact that we’re running budget deficits for since I can remember, it gets concerning. Tax revenue likely will need to go up in the future. They can raise tax rates to do it, or they can just use inflation to do it, I guess. But that’s beside the point.

So all this to say, in order for the tax qualified program to truly be a tax saving device, you would have to know pretty sure that whenever you come to go get the money at some later date, that that money is going to be taxed at a lower rate. The problem is we just don’t know that. So essentially, what we’re accepting when we dive in, is that there’s a certain amount of money that’s yours and a certain amount of money that’s going to be the government’s money, the IRS. We just don’t know what that is.

This is one of our big problems that come for this, Holly, if we want to branch into the ramifications of this thought, most people that we talk to who have decent balances in these retirement programs, you get this feeling that you’re richer than you actually are. Because you see this big number on an account statement. You see this big number when you log into your online portal. But then there’s this hidden amount of money and the problem is at any given moment, you don’t know how much is yours and you don’t know how much the IRS is going to take. That’s a little bit risky. I don’t really love being in that position.

Holly:  I was talking to a client the other day that was telling me how they’ve really bought into this retirement program. Tax deduction in their mind, not deferred, and having to explain, “Well, no, it’s not a deduction. It is deferred.” Now this individual’s put right around $500,000 into a retirement program over the course of his life. He said, “But I have that entire $500,000.” I’m like, “You’ve deferred your taxes on all of it. Has your tax bracket gone up or down in the course of your lifetime?” He goes, “Up.” I said, “Well, do you think you’re going to get more deductions when you’re older or right now?” He goes, “Oh I have kids right now. I get my kids’ deduction.” I said, “Well, eventually your kids grow up and move out, you don’t get those deductions anymore.”

Nate: So essentially, what you’re referring to there Holly is that more and more people are actually legitimately retiring right now and they’re realizing that with the loss of deductions and with Social Security income being taxed, if you make a certain amount of money, 85% of your Social Security income is being taxed alongside all of your qualified program withdrawals or maybe you have a pension. And suddenly, you are hoping to be in a lower tax bracket and you find yourself paying as much or more. In exchange for that, you had to rid yourself of the use of the money and live on whatever was left for 30 years, hoping to end up saving some money on taxes. It turns out, it may not happen.

It might happen though. I don’t want to be too antagonistic. I’m going, “Okay, it would make sense if tax rates don’t go up and your income goes down and then you decide to retire, then yeah, you would’ve save some money. But it’s a tough way to win and it’s an odd thing to hope for it. It can breed some problems whenever you’re thinking of them as saving money on taxes, which I think is just, I don’t know why accountants talk like that. Maybe just it’s easier. It makes them feel better that they can help you lower your tax bill this year. But true tax planning should be about reducing the amount of taxation owed over a lifetime. Not just getting a quick tax break right now and possibly actually it being negative for you depending on where you’re at.

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Holly: We don’t have a magic ball that’s going to tell you what tax bracket you’re going to be in 10, 15, 20 years from now. And so, you have no idea how much of that money you actually are going to have to be able to use or retire on because we don’t even know what tax bracket that is. And if you look at the history of taxes in general or on average, most people actually make more money when they’re older, and they actually end up being in a higher tax bracket in their latter years, not in their 80s or 90s. I’m not saying that, but in their latter years, because the deductions are actually less than what they had when they were younger.

Nate: We’re just focusing on the tax side. I mean, there’s all these limitations of using the money that if you buy into the control philosophy. So this would be like the Infinite Banking Concept group. This would also be like the Robert Kiyosaki style group and many other groups, entrepreneurial groups, where being in control of money produces a whole bunch of great results that passive retirement planning and investing doesn’t really produce, or doesn’t nearly get you to where you want to go. And the financial freedom that it produces oftentimes can be very mirage-y. I don’t think we need to necessarily dive into that.

But just regarding tax taxes, you’re absolutely right, Holly, that it’s an interesting thing to think that tax-deferred programs are helping me save money on taxes. They could, but there’s no way to know today if it actually will save me money on taxes. That’s the problem.

And what’s crazy to me is you’ll see, especially young people, if I could talk to young people, people in their 20s and 30s, if you’re going to run for 30 years or more potentially, and most of the time early on in your career is when you’re earning less money in your 20s than you are in your 50s. But we’re still told, “Defer taxes today.” Where it’s actually unlikely that as you’re starting out, that your tax bracket is going to be higher today than it will be in the future whenever you hopefully have been successful.

So, here’s what I would say for tax deferral concepts. If you’re making a high income and you’re in the later years of your working life, in other words, if you are 63 years old and you’re about to retire and you know exactly what the tax brackets are, you’re 64 and you know exactly where the tax brackets are today, and you know that you’re going to retire soon, and you know what income you’re going to be pulling out, and you’re like, “Okay, it’ll be less income next year because I won’t need as much. Or maybe if you’re that close, we can make an argument for it. But the further away you get, the crazier, it is to trust in a tax deferred program to actually be a good tax planning device.

Holly: Most people do it, Nate, because of that mindset. It goes back to, “Oh, it’s a deduction.” You have to change the mindset that I’m just deferring that tax payment right now. It just means I didn’t have to pay it this year. I don’t know what I’m going to going to have to pay in the future, but it is not a tax deduction. It’s a tax deferral.

Nate: It’s not even fully just a tax deferral as we bring that up. The more I think about it, it is just an income deferral. That’s really what it is. If I am in the 25% tax bracket, let’s just say the 30%, it’s easier to do math with, and I’m going to put $10,000 into a tax deferred program and I’m in the 30% tax bracket, the accountant will pitch it that you’re saving $3,000 in taxes. That’s 30% of the 10,000. So your tax bill will be $3,000 less. But it’s not like we’re saving this three grand. What we’re doing is we’re saying, “I don’t have any use for this $10,000 so I don’t want this income right now. I want to

put it in income jail,” as I talked about, “and I’m going to move that 10 grand over there. And that $3,000 of tax, I may pay it later, but I just don’t want to use this money now.”

That’s what we’re saying. I don’t want this money today. The government is allowing me to put it in income jail, and then draw it out later as income and pay taxes on it then. It’s actually deferring income. It’s what it is. It’s just a way to defer income into the future and people pitch it as a tax savings device. That’s not what it is. It’s an income deferral. You can take that income out in the future. Hopefully, it’s in a lower tax bracket. People are finding out it’s not going to be.

Then even after death, if you pass away and you have these tax deferred assets, it’s not like your beneficiaries are off the hook. The IRS is going to get its tax that it’s owed to itself. So even if you die, your heirs are restricted. If they have to start pulling out the money, and they have to do it over a set amount of timeframe, and they got to get all the money out or they get penalized. So, there’s required withdrawals, which could wreak havoc on those individuals, especially if they’re in the prime working years of their life. They’re forced to take out these withdrawals or just give it up in fees. So, they got to take the withdrawals out and pay taxes at whatever their income tax bracket is. It actually becomes an even worse legacy planning tool than it is tax deferral because many times your heirs will have no choice. They just have to pull out whatever the tax rates are at their current income level, which can be kind of disastrous. A lot of the money can walk out the door.

Holly: I think in general, if you have questions, you need to ask them, but you also need to not just look at what you’re doing today, Nate. We can’t predict the future, but sometimes that, “Oh, sounds so good,” “Oh, I don’t have to pay taxes on this,” we think in our mind we’re saving money. We’re actually spending money to save something that we don’t actually know if we’re actually going to even save anything.

That’s a good point. I think that’s a common misconception though, just in tax planning concepts anywhere where people will talk about how I need to keep doing this because I’m getting a tax deduction for it. Just because you’re getting a tax deduction for it does not actually mean that you should do it. Until the tax is 100% of your income, if you spend money to get a tax deduction, you’re actually just spending money. I hope people understand that it is nice to do things that give you a tax deduction because that means that the cost of whatever it was is now less. So I like to run as many things through my business as I can because I’m going to be spending the money anyway, and I would like to have my business purchase and own as many things as I legally can have it do.

But I find, talking to other business owners, sometimes they will spend money on things that they don’t actually need or want, but just to save money on tax. I’m like, “Well, I mean, I’m glad that you’re getting a tax deduction to do that, but does your office building really need the hot tub? Is it going to help you?” I mean maybe it does, but that’s the definition of the nickel hiding the dime. If I’m in the 50% tax bracket and I spend $10,000 to get a tax savings of $5,000, I’m still $5,000 less than what I started. So the question is, what did I get for the 10 grand? Do I actually need it? Do I want it?

Get as many deductions as you can, but it is common to think of deductible expenses at this pedestal. Like, I got to do everything I can to make sure I keep spending money on this thing because it gives me tax deduction. Well, you just always have to keep in mind that the tax deduction itself is never worth more than the dollars that were spent to get the tax deduction. So that brings up another kind of pet peeve that sometimes I’ll run into taxing.

Holly: Think about it before you do it because it’s not always in your best interest to tax for it or like I just said and Nate said, “Oh, I’m going to go spend money.” I’m still out money. It doesn’t matter. It probably would’ve been cheaper sometimes to not buy that thing that your office really doesn’t need to save the money.

Nate: The fact that you’re getting a tax deduction itself does not make it a good idea. It should be a good idea regardless and the tax deductibility of the expense just makes it better. For me, I’m going to give to charities regardless if it’s a tax deduction or not. The fact that it’s a deduction to me is just icing on the cake. But remember, I gave a whole bunch of money last year to charities and it’s not like it saved me more in taxes than what I gave. I’m not receiving more benefit tax-wise.Just keep that in mind, too. That can be another pet peeve that I have when speaking with people is that you’re spending money to get a tax deduction that ends up costing you more money anyway, and you don’t actually need the thing.

So, a couple of pet peeves of ours, but certainly when it comes to the tax deferred programs, they are not tax savings devices in themselves. They’re simply income jail that we will get the income out of income jail past age 59 and a half. And we’re finally able to get it out without a penalty, but whatever the tax rates are owed on that money will be determined at that time. Beware whenever you are making large contributions to tax deferred programs to save money on taxes, make sure that you’re doing it with the end in mind. If you truly believe you’ll be in a lower tax bracket for certain reasons that you have that will pan out, then it’s a great choice. But if you haven’t thought it all the way through, don’t just let your account say, “Hey, I can save you money on taxes. Let’s contribute to this IRA.” Well maybe you do, maybe you don’t. But don’t let the tax deductibility of the transaction or the tax deferral ability of the transaction be the end all for choosing that option.

That being said, yes, this has been Dollars and Nonsense. If you follow the herd, you will get slaughtered.

Holly: For free transcripts and resources, please visit livingwealth.com/e141.

Announcer: Dollars and Nonsense podcast listeners, one more thing before you go. Ease your worry and start your journey towards security today. Visit livingwealth.com/secretbanking. You’ll gain instant free access to the special one-hour course Holly and Nate made for you. Again, that’s livingwealth.com/secretbanking.