"The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration."
16th Amendment to US Constitution, Ratified February 3, 1913.
No other words make as much of an impact on the choices of Solitude as this one simple sentence. The irony is that client fear and avoid taxes. They fail to realize the above sentence means that income can be taxed to a population of just one person ("Without regard to census") or at any rate or amount without specification ("enumeration"). That means a tax law with only your name and a 100% rate remains constitutional. We teach our clients to EMBRACE the tax code, and avoid tax deferral whenever practical. This is somewhat unique in the world of financial advice. As you read the following, review and refer to what we believe are incontrovertible tax "Truths":
- Taxes apply most significantly to income, less so to capital gains or dividends. Seeking the latter and avoiding the former improves outcomes.
- Retirement is generally funded with BOTH stored and guaranteed income, making taxation of income a constant problem that requires active management.
- People work hard to make more money, creating increases in income and higher tax brackets, meaning their rate of taxation in the future is always the same or higher
- Taxes go up over time, and are vulnerable to increases in the future as the US becomes more indebted
- Large deferred IRAs (over $1M) are a problem, as they are subject to significant future tax loads during distribution. This is especially true after age 70 and a half.
- Many of our clients will face larger tax brackets in the future due to diligent deferred savings, and the penalty of single filing after the death of their spouse. They would be better off getting taxed now, not later.
- Roth accounts, health care accounts, and taxable accounts are excellent alternatives to storing income in a deferred IRA or ERISA Account
- Even the high salary worker (in the 33% bracket or higher, joint taxable income above $200,000) has excellent post tax options if they choose to avoid a current deduction.
- Deferred accounts are poor methods of estate transfer, as inherited IRAs face a "forced march" of distributions regardless of the inheritor's other tax problems. Creatively distributing deferred assets during the original owner's lifetime is a superior method of creating cash and Roth assets, with far superior estate transfer values.
Let's discuss why we feel so strongly avoid embracing taxes. Notice that the 16th amendment applies to precisely one and only one thing: income. So perhaps we need to review what is income (generally) under current US law;
- Capital gains for assets sold with a holding period of less than one year
- Salary, wages, and tips
- Non-qualified dividends
- Brutally, any method of gain in a deferred account (traditional IRA or 401k). Dividends and long-term gains lose their advantages in these common retirement accounts.
So lets look at the mechanism of tax deferral. A person earns $10,000. They elect to save $5000 of INCOME, or half of it, in a deferred IRA. They receive a tax break that is worth nothing, and then freely elect to give up some of the future growth despite the fact they could have kept it all in the first place. This is because the investor is always better off giving part of the gains to the government now. Because governments will spend it well. Just kidding on the last sentence. The rest is true.
WHAT? Wait, you can't mean that they could have kept it all. Well, of course I do. You see in the above example the level of income is so low that the likelihood of any tax due is about zero. Before you say the example is unrealistic, how many of you parents are telling your low pay kids - earning less than $40,000 salary per year - to sock dollars into their deferred 401k? So the deferral is worthless, but the future taxes will depend on two unknowns, and one known:
- The amount of income in the year of withdrawal
- The tax rate on that level of income in that year
- That the person will attempt to achieve a higher tax bracket during their entire lives
I think most people would instinctively agree that tax rates will tend to float up over time. So then why do they turn right around and defer instead of taking the government up on their current rate of taxation? Because they find paying taxes so painful that deferring them seems like a good idea. Which is then by definition a bad idea, as tax PERCENTAGES tend to grow over time.
Hey, but we are getting the benefit of deferred growth, right? No. The government is getting the benefit of deferred growth. If they had received the payment now they would have blown it quicker than an eight year old in a candy store. You actually invested it for them, worried over it, paid me to manage it (remember asset managers get a percentage on the amount regardless of who owns it), and grew it to a much larger size in a future year. It is pure math.
In the above example you defer the $5,000 and you are in the 0% tax bracket. (Note - tax brackets will refer to ones that will return in 2026 - lower ones now are temporary) If you repeat that process 10 times you now have $50,000 in stored income. If you draw that out in one chunk you are now in the 15% bracket and it is tax to the tune of $7500 plus state and local. If you had not done that, but instead put it in a Roth you would have owed zero. If you had put it in a taxable account, you would have also owed zero (we are not talking about gains yet).
Well, Gene, that is just stupid. Nobody would do tax deferral if their current bracket is lower than their future bracket. Well, folks, I submit they would do exactly that, because you are doing it now. Seriously, when was the last time someone told you tax deferral was a bad idea? Like never. So that means EVERYONE is out their running the exact same playbook. Some investment guru takes a call from a worried citizen, and recommends they start saving in their 401k. They never ask "what is your current tax bracket" or "do you expect to retire in your current tax bracket" or "what is the likelihood that your current tax bracket will apply to the income withdrawal rate you will choose in retirment". Nope. Like lemmings over the cliff, stampeding to a retirement funded with piles and piles of stored income seems great. I mean, who wants to watch $10,000 of my precious salary get mowed down to $7500 by the feds and then the state whacks it down another $500 to $7000? It looks so much more puny in my Roth. $7000 has to be less than $10,000, right?
It isn't. They are the same! They represent the same amount of current buying power at the grocery store since the 16th amendment says you can't have the entire $10,000 until you run it through the tax code. And that is under the big assumption that the future of taxation will be as friendly as it is now (I mean that - check out a European tax scale sometime for some scary percentages).
Let me characterize the true nature of tax deferral. Let me even grant that you are in the 25% tax bracket, and that $10,000 deferral is giving you a $2500 dollar break on taxes. It is still a poor choice. You think you are being allowed to keep $2500 of YOUR MONEY. YOU ARE NOT. You are being forced to manage $2500 OF THE US GOVERNMENT'S MONEY (remember the 16th amendment - you only get to keep the income they say you can). That $2500 is theirs, period. They will keep it whether you defer or not. It is as though you have gone into business with the IRS. You have supplied 75% of the capital (the only part you EVER owned in this deal) and they supplied 25% (theirs by law).
There is only one little wrinkle. You let the minority investor retain the voting rights on the future distribution of capital and profits. Oops. That doesn't sound good.
Well, it's worse than you might think. It is one of the most efficient ways to destroy MONEY - a most valuable post tax version of money called "Basis".
That means the US congress can get up tomorrow morning and pass a law stating: "all income in the US will now be taxed at an extra 5% to pay for Social Security". You realize "hey wait a minute, that means an extra 5% is coming out of my cut". Bingo, you win the prize. You would now only retain $7000 if you made a withdrawal of the income, an effective loss of $500 of what was once YOUR MONEY. The pundits of the "power of compounding makes deferral a no brainer" must have flunked math, as a 10-fold gain makes no difference in your cut. You still could have had $75,000 in a Roth (all yours) and now must settle for $70,000, and less after state taxes. A taxable account is more complex, with options that are generally worse (about $64,875 for realizing a long term gain) to about the same, if the asset is given away to meet charitable giving goals or gifted. The real key to the taxable account is that it reduces income tax risk and has options that are not available to the deferred account that can make up for some of that shortage in a hurry.
You stepped into a rip-off because you thought the transaction was benefitting you, not the United States. I am afraid that the quicker you adopt the idea that getting income taxed as soon as possible is the best strategy any sane investor can adopt. It gets the INCOME and the 16th amendment out of your money and improves you choices dramatically. The only exceptions to this idea live at income rates well past $250,000 per year for married couples, maybe $180,000 for singles, and even then immediate taxation can make sense well beyond those numbers with sufficient asset planning.
So why do you believe so differently? Because you have misread the agendas, I'm afraid. Even your current financial advisor is probably against you here. So I am going to put all the cards on the table and show you my hand for emphasis.
Like most financial advisors I get paid based on the assets I manage. If there is $10,000 in a deferred account and the fee structure is 1% my firm will get $100 a year to manage the assets. If the $10,000 is run through the tax code by the client and put into a taxable account or a Roth 401k, I will be paid on the remainder of $7000 or $70 a year. Let's see here, what should we recommend? Boy, sounds like we advisors are getting on the bandwagon of lovin' tax deferral!
Look at it on a larger scale. If I coach my clients to max out the 401K from age 50 to 65 ($24,000 per year) I will manage about $360,000 in pre-tax income and pre-tax gains. If they chose the Roth 401k option in the 25% tax bracket, I manage only $270,000. This is a difference of nearly $900 per year in fees for just one client. We haven't even started to talk about the deferred gains in future years.
So in reality, if a client defers $1 million, they pay me $10,000 in fees, $2500 of which manages the goverment's portion, which was never theirs to begin with. If they had moved (to a Roth or taxable account) the only part they would EVER have been allowed to keep, they would have paid me the fees only on that smaller portion, perhaps $7500 per year. Now that doesn't hurt them (remember in both cases the post tax amounts are the same), it hurts my firm, as I pay taxes on the income no matter whether it came from their pile of money (Roth, taxable) or their pile of income (401k or deferred IRA). That is why advisors want clients to defer income, not accelerate it. BESIDES - your advisor is well paid and in the highest of tax brackets so they think your need to defer is critical as well.
We have reached another brutal truth. You are told to defer taxes in a large part because the US government and your advisory firms are VASTLY better off when you do.
Ouch. Really? Yes, really. All of those reinvested deferred taxes will never go to you, they will go to Uncle Sam and your investment advisor's club dues. If your portfolio doubles in a deferred IRA, the amount owed in taxes doubles. No gain whatsoever on the deferral. I am appalled at the "power of compounding in a deferred account" article. They stupidly (I mean that) think that if the dollars are "more" (that is true) that the client can "buy more" in retirement (that is false). Even some financial software struggles around the idea of how to best advise a decision when it involves the tax code and pretax versus post tax outcomes. Too often the answer that generates the most dollars "wins", even if it leaves those dollars dangerously exposed the needs of the US Congress.
To win on deferring taxes, one has to drop a bracket from the year of the earning to the year of the withdrawing. Which rarely happens. Because that stinks.
Why? Look at a typical life. You start babysitting, or delivery newspapers as a teen in the 0% tax bracket. Then you work to put yourself through college barely making enough to even need to file, and then get your first real job firmly in the 15% tax bracket. But who aspires to stay there - making barely enough to support one let alone a spouse and children? So you diligently work on making it to the 25% tax bracket, which lives just north of the median income level in the US. Here, you make the majority of your savings, so you hope to defer in the 25% bracket and pull in the 15% bracket.
In other words you are hoping to retire at an income level that is below the median income level. So now tell me, who is out their gunning for a meager retirement, the kind without the resources to travel or have fun? The kind where you really have to think about each purchase, clip coupons, budget every penny? Or do you want the kind of retirement where there is enough extra room to do the things most of us hope to do in retirement: maintain our current lifestyle, travel, and pass on a legacy to our favorite people or charities? Those goals do not live below the median income level. They live firmly entrenched in the current 24% (2026 and after 25%) tax bracket, between $70,000 and $160,000. The quicker you give up on deferring for a better tax situation in the future the faster you can get past the 16th amendment and start acquiring assets that will act like property. This means Roth and taxable accounts, NOT deferred accounts.
BRUTAL TRUTH, much more bluntly:
People spend their entire lives trying to reach the next tax bracket and when they get there they want to stay there. Therefore most people will retire in the highest bracket in which they ever worked. So deferring in early years virtually guarantees the same or higher tax losses in retirement. This problem is magnified by the death of a spouse, which then exposes the same levels of income to dramatically higher rates of taxation.
Their are ONLY four situations that are improved by tax deferral:
Uneven income, where you are earning much more than your lifestyle or are earning a great salary one year, and a low one the next.
Entering the 32% tax bracket, which generally begins the tipping point on other taxes resulting in total (state, federal, sales) tax losses approaching 50% in some states.
401k matching. This tremendous advantage can easily overcome the tax issue, but be careful to only put in the matched amount to get the full match.
Deferred savings when the total of all deferred amounts at age 65 is projected to be less than $500,000. In these situations, most lifetime income distributions will "fit" into the lowest tax brackets where the effects on other assets (like Social Security and dividend income) can be controlled.
That means unless you earn north of $320,000 of TAXABLE INCOME (line 10 on your lovely form 1040), tax deferral is likely to get in the way of improving buying power in the shortest amount of time. That is a staggeringly high amount of income before deferral should even be CONSIDERED. For the average American, that means most of you should stop pumping up your deferred 401k and start pumping up a Roth IRA or 401k and a fully taxable account.
We consider our greatest tax victory to get our clients "through" the tax code at some point in retirement, where the only investment accounts they have are Roth and taxable accounts. The small amounts of taxes they pay annually in these situations never fails to make me smile. While not every client will achieve this level of tax freedom, a focused approach on smart tax realization will benefit them and their legacies for generations to come. Tax risk is simply the risk most Americans don't see, and most advisors don't address. We do.
Want to tax plan with an advisor that see your problems and the IRS/Advisor conflicting agendas? Call us to see what we can do for you!