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Qualified Retirement Plans: The Hidden Truth

June 19, 2019
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For many people, the term “401k” or “403b” is synonymous with retirement preparation and sometimes is the full extent of their financial preparedness. Such accounts are usually part of an employee benefits package and chances are, if you have one, most of your retirement savings are deposited into this account. As it can play such a prominent role in your financial future, it is imperative you fully understand exactly how these plans work.

So what do Qualified Plans do exactly?

Most of us know that they defer taxes, which is true.  However, the term ‘defer’ often leads to a misunderstanding.  Some people misconstrue that “deferred” taxes are taxes they are “saving” because the taxes do not have to be paid, which is NOT true.  These are not ‘tax savings’ plans but rather ‘tax deferred savings’ plans.  The government did not say you don’t have to pay taxes on the dollars in your Qualified Plan; it said you don’t have to pay the taxes now.

If not now, when?  Well, later, obviously.  The key difference between now and later relates to your tax bracket: the bracket you are in now versus the bracket you will be in when you take money out of the account. If you defer the tax and your later bracket is higher, your share of the account will be less.  If you are in a lower bracket when you take the money out, then you will get more.  The IRS is not concerned with your bracket when you deferred the tax, only the tax bracket you will be in when the money is withdrawn.  Because this is true, you need to make an informed decision as to which option is best for you.

Assume you call me one day and want to borrow $10,000. I hand you the check, but before you take it you are going to ask me two important questions. The first is how much interest am I going to charge you, and the second is when do you have to pay it back.  Suppose I said to you, “I am doing fine right now and do not need the money, but there will come a day when I need it, and when I know how much I need, we can figure out how much interest I need to charge you to get the amount I need.”

Would you cash that check?  Probably not.  But you are standing in line to do exactly that with Uncle Sam in your Qualified Plan. Uncle did not say that you don’t owe the tax; he said you can pay the tax later.  At what rate?  That is the nagging, taxing question.

Understand that Qualified Plans do two things:

  1. They defer the tax, AND
  2. They defer the tax calculation

Ultimately, the impact these plans can have on your financial well-being, either positively or negatively, depends on a number of factors. The first and most fundamental of these is your knowledge and understanding of the rules of the game, and then, second, the strategy you must use to win the game.

You may not remember the first time you played tic-tac-toe, but you can probably remember who won.  It was likely the person who showed you how to play the game. Only a few rules: one is the X, the other, the O, three in a row wins. When we first learned this game as children, we lost repeatedly until we learned the strategy of the game.  If you have dollars in a Qualified Plan, you are already playing the game.  As an adviser, it is my job to help clients employ winning strategies with an informed understanding of the rules of the game.

Just as a business owner should not count solely on the sale of his business when he is 65 or 70 to create a retirement fund, an employee would be wise to know the ins and outs of comprehensive retirement strategies, starting with a thorough exploration of his or her current Qualified Plan(s).  Then, it may behoove that owner or employee to consider alternative or additional retirement savings strategies to assure a comfortable, secure, retirement.

If what you know to be true about Qualified Plans turns out not to be true, how soon would you want to know?