The Last Chance Millionaire: It's Not Too Late to Become Wealthy
By Douglas R. Andrew
For years, you probably have been bombarded with information about how you can save for your retirement with the help of IRAs and 401(k)s. Your CPA or financial advisor may have pleaded with you to contribute pre-tax or tax-deductible dollars into these so-called qualified plans because, as they understand it, this will shelter your money as you accumulate it.
They tell you not to worry as you get ready to reach into those savings when you set a retirement date or when you hit the age of 59/4. Your nest egg will be bulging, they promise.
As we have seen, there is value in having your money grow tax-free. But I've found very few advisors understand that, like the teacher I described in the previous chapter, you may get clobbered by taxes when you actually make those withdrawals. Let's examine these much touted retirement plans closely.
First, let's look at the premise of a lower tax bracket during retirement. You may be thinking, "Doug, I'm small potatoes. I'm not in a high tax bracket now, so I'm not going to worry about paying high taxes later."
Regardless of your current tax bracket, I would rather see you think about it now-and do something to ensure that you won't be hit with a tax bill you never saw coming. It's a lot easier to prevent unnecessary tax now than try to cure it down the road.
A Short Detour into Recent Economic Policy
Before going any further, let me take a short detour to talk about the economy and taxes. Do you think taxes will be lower in the future? In seminars, I ask for a show of hands on this: "Do you think they'll remain the same as they are now? Or will they be higher?"
You won't be surprised to hear that the largest show of hands is for "higher." Most people expect taxes to increase. But usually, someone will say, "Wait! In 2001 and 2003 President Bush sponsored and Congress passed the Economic Growth and Tax Relief Reconciliation Act and the Jobs and Growth Tax Relief Reconciliation Act respectively. These acts raised the tax thresholds and thus put many people in lower tax brackets. So why can't we expect new tax cuts, rather than increases?"
My reply is that those tax changes were passed merely to stimulate the economy. Why? There are two political philosophies: one is that you raise tax revenue by raising taxes, while the other is that you raise the revenue that will get taxed to generate more tax revenue. President Bush wanted to raise the revenue after an unusual period of events that impacted the economy.
Remember back before the year 2000? If you recall, with all the fears of computers' Y2K incompatibility, the Federal Reserve did not want anyone to go to their bank or credit union and be unable to access their money at the turn of the century. Through a series of interest rate reductions, the money supply was increased. Then came the bounce after Y2K, followed by a decline as the dotcom bubble burst. Interest rates were damped down. Then two planes flew into the World Trade Center towers and the markets plunged. Shortly thereafter, workers around the country lost their jobs because of the crisis. Anyone whose assets were not liquid had a terribly bumpy ride during those years.
Looking ahead, there is lots of talk about whether the estate tax, often referred to as the inheritance tax, will indeed only be repealed in 2010, or whether Congress will allow it to disappear entirely. As I write this, the estate tax applies to any estates over $2 million. While the 2001 tax cut reduces the estate tax each year and eliminates it in 2010, it is set to return in 2011 to its year 2000 schedule.
I think plans to phase it out are a big tease. The Boomer generation is on track to transfer the greatest amount of wealth in the history of the world to a younger generation. As a trade-off, after repeal of the estate tax, the current law providing a step-up in basis to fair market value will be repealed. (I explain this in more detail in my original work, Missed Fortune.) Suffice it to say that if the step-up in basis on long-term capital gains is modified, inherited appreciated assets may be subject to increased capital gains taxes when sold.
The bottom line is, you know the government will collect its tax money one way or another. With federal deficits, Social Security issues, and the war on terrorism all demanding attention, it would behoove you to assume in your retirement planning that there won't be another tax reduction act anytime soon.
Does it make sense to postpone paying taxes for an advantage you may never enjoy? No! Does it make sense to postpone paying taxes when you're convinced you'll be in a higher bracket? No! Does it make sense to let your retirement accounts grow into a big nest egg, then pull money out when your taxes have gone up? No!
The two lessons you can learn from all this are:
It's best to be in a position of liquidity and safety so you can always act, rather than be forced to react to unanticipated events in the world.
Rather than postpone the inevitable taxes, you need to discover a tax-advantaged way to enjoy your retirement.
Why not have it all? I don't want to pay unnecessary taxes on my retirement funds at any point whether it is now, on the front end, or later. I want to put my money away in a tax-favored environment and then withdraw it without paying taxes. Don't you?
What's Your Tax Bracket?
You're about to learn how to deposit 100-cent dollars at the front end of your retirement savings and how to withdraw 100-cent dollars on the back end (during retirement). But first, you need a primer on how tax brackets work.
In 2007, there are six brackets for the purpose of computing federal income tax. Figure 5.1 illustrates the percentages and thresholds.
We can't be sure how tax thresholds may change in coming years. But for simplicity's sake, I'd like to use one bracket to illustrate my points. If you are a typical American taxpayer, you are probably in (or close to) a combined federal and state income marginal tax bracket of 33.3 percent right now. A couple filing a joint tax return in California earning a combined income in excess of $63,700 in 2007 would be taxed at 34.3 percent on all dollars they earn over $63,700. To illustrate these concepts, it is simple mathematically to assume that exactly one-third of your income goes for taxes. Whether your state has an income tax or your actual tax bracket is higher or lower, the concepts remain the same, so you can interpolate any illustrations in this book for your personal income tax bracket.
Bear with me-it's important to know what this all means and the dramatic impact it can have on your retirement resources.
Taxable income is calculated as adjusted gross personal income, minus personal deductions and exemptions. Deductions are allowed for expenses or investments that directly or indirectly contribute to civic assets or otherwise stimulate the economy. You are allowed exemptions for dependents, such as children living at home. If you are an entrepreneur or are self-employed, there are many legitimate business deductions that may reduce your taxable income. Itemized or standard deductions and exemptions are subtracted from the last, not the first, dollars you earn each year.
A taxpayer who files an itemized federal tax return will list these deductions on Schedule A of the 1040 federal tax return. There are currently three primary categories that you typically deduct when you file this schedule (as opposed to a short form or taking the standard deduction):
State income and sales taxes, plus local taxes such as property tax
Cash and noncash charitable contributions
Qualified mortgage interest expense
Under hardship circumstances, excessive medical care costs and casualty and theft losses also qualify. So do health insurance and other medical costs for self-employed taxpayers.