This simple question creates a quick response – NOW! We don’t like to be wrong; it goes against human nature. But when someone points out that we may be wrong it is also hard to take. This is the pride factor. Most people pride themselves on knowing what they are doing either through past experience or knowledge. Thus, the quick response and simple answer of now, turns into a longer drawn out process of overcoming pride or replacing what is on our belief window (in our mind) about this topic. The knowledge we have must be retrained or re-taught and this means effort, or more importantly, admitting we were wrong. We prefer to think of it as educated with the wrong data. Let’s try putting this into action.

Let’s assume you were taught to put the maximum amount of money into a tax-deferred investment such as a 401k or IRA account. This is the window of belief in your mind. What happens if I tell you this is not the best method of saving for retirement? Would your defense mechanisms go up automatically? Would you try and defend your position of belief? If you are normal, then the answer is absolutely. Thus, “if what you always thought to be true about tax-deferred investing wasn’t, when would you want to know about it?” The response to this question would be now. This is different than me telling you, you should not put the maximum into a 401k or IRA account. In other words, what if we take the latter premise – “if what you always thought to be true about tax-deferred investing wasn’t” – you would like to learn more. So, let’s learn more. For example sake, we will simplify this to the following scenario. If you as an investor in a 401k account deferred $500 per month or $6,000 per year, assuming a 28% tax bracket, you would avoid/save $1,680 in taxes. If we assume you work for 30 years under this scenario you would invest $180,000 and avoid/save $50,400 in taxes over that period. Sounds good doesn’t it. Now, let’s go one step further. The growth of the money at 10% annually would bring the worth to $1,139,662 in 30 years. Thus, what we understand is true about tax-deferred investing. Or is it?

As Paul Harvey says, “Now for the rest of the story.”  You retire and want income from the account. Let’s maintain the same growth of the asset at 10% and take an income stream (distribution) at 6%. This allows us to maintain a growing income each year and never deplete the principal. Thus our income is $68,000 per year taxed at 28% or a net of $48,960. This is the opposite of what was happening when we accumulated the asset in the account. If we are retired for 25 years we would pay taxes of $476,000. We saved $50,400 in taxes during the accumulation period and paid $476,000 during the distribution period. Now my eyes are open to the fact that I paid almost ten times more in taxes than I saved. The important lesson is we aren’t done yet. What happens if you die? To keep it simple we spent $68,000 or 6% each year on the principal balance starting at $1,139,662. In 25 years assuming a 4% (difference of 6% spent and 10% earned) compounding rate of return we would have $3,038,152. How does this pass to our heirs? The correct answer is taxable. Except now we have income tax and estate taxes with which to contend. The total could be more than 60% in some cases meaning we will send $1,822,891 to the government on top of the $476,000 we already paid or a total of $2,298,891. This tax-deferral thing is great! But, remember you saved $50,400 in taxes.

There is more detail to understand in this simple example but the fact remains. What we always knew to be true about tax-deferral wasn’t. Now that we know, what we do with it is entirely up to us. In most cases we would need to research the details and find out what alternatives we have, if any, and how to diversify the taxation of our money so we keep more than we share with Washington. The point is simply this – what we know to be true today may change tomorrow. If we are not flexible enough to change with it we could end up at a destination we weren’t intending. Open your mind to learning and become a better investor by learning more while applying it to your money to maximize the benefit to you—and not remember you saved $50,400 in taxes.
There is more detail to understand in this simple example but the fact remains. What we always knew to be true about tax-deferral wasn’t. Now that we know, what we do with it is entirely up to us. In most cases we would need to research the details and find out what alternatives we have, if any, and how to diversify the taxation of our money so we keep more than we share with Washington. The point is simply this – what we know to be true today may change tomorrow. If we are not flexible enough to change with it we could end up at a destination we weren’t intending. Open your mind to learning and become a better investor by learning more while applying it to your money to maximize the benefit to you—and not to Washington or others.