PODCAST EPISODE 287 Young + 401(k) = IRS Wins

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0:12

Hello, and welcome to sound financial group podcast. My name is Paul Adams. I’m the founder of sound financial group. I’m also good friends with Corey Shepard, look at that beautiful man. But I’m so glad to be joined by him president of sound financial group and us get a chance today to tell you about a serious problem I have like if we had a rant episode, this would be a rant episode for me.

0:37

So and for once, like, I completely agree. I almost said almost, I almost said almost

0:49

full disclosure to our audience, full disclosure, he may go back to almost by the time we’re done. So here here is one of the things that that we see and run into all the time is people putting money into retirement plans. Now retirement plans are supposed to be treated with a fiduciary standard, regardless of the adviser that might be recommending it. So I think

1:15

government has increased the regulation around retirement plans. So even if you’re not a fiduciary raa like we are all the time anyway, you’ve got to be there. And and we have to do even more than we normally do for any other account just to document it now, like it’s a big deal,

1:37

like so to give everybody a for instance, is used to be just explained an investment to a client and we’re going to do this instead, we transfer and rollover, say a retirement account. Now there’s a one page email that has to be sent to them saying, here’s the exact differences between each of your accounts, all that it’s all meant to elevate the standard by which advisors would give advice, as dictated by this federal regulation. Now, commence rant, what we’ll do is have zero problem, zero fiduciary standard zero recommendation standard on whether or not people should put money into traditional 401 K or Roth. Now, I want you to think about this a little bit. So let’s take let’s take somebody 40,000 years old Corey single, no married yet. That $40,000 a year of income in their 20s, not 40,000 years old. Thank you. He’s head head of compliance too. That’s why he catches all those little things. So what what are they paying their top tax bracket keeping in mind that they have a $12,000? deduction? Right, right off the bat?

2:54

Yeah, so for a single person, a single filer in 2023, the 12% bracket starts at 11,000 of income goes up to 44. So they’re making about 40, they get the standard deduction, there’s they’re just right in the middle of that 12%.

3:13

bracket. So if they’re making a little less than 40, they might be down in the 10% bracket a

3:18

tent, while the 10% bracket only goes up to 11,000. So okay, yep, there go. It could be, you know, if they’re in there in the 20s, then their deduction is taken them down. And maybe Yeah, so 12%, I think is a good one to go with, most likely. All right,

3:35

so let’s go to the whiteboard here for a second. So when we’re looking at putting money into a retirement account, here’s what we’re up against, we get to deduct the money from our income. Now, it goes into this account that we’ll call tax deductible IRA or 401. K, but I’ll just stick 401k for now. And if you put that contribution in before tax, we got a tax deduction came out of our pay before taxes came out of it, then we’re going to pay the tax on the back end. Now, what happens for a lot of people is they think about that before and they say, Well, yeah, I’m gonna get to avoid a 12% tax. And that’s good, because now the IRS is money is invested next to my money, and therefore, I hope I’ll be able to make more over time. But quarry that same person, if they have a pretty good career, etc. We don’t even need to say the highest tax rate, let’s just say it’s 30%. Okay. Which by the way, is very, very low. If you’re in a high income realm anywhere in California, that 30% is a well under estimate. So we’re trying to be conservative here. So if on the back end,

4:53

there would be 24% federal, plus some California after deductions around 30 Yeah,

5:01

yeah. So we’re not talking about somebody become a warren buffett by the time they retire, just that they did. Okay, and now they’ve got some money set aside. Now, if what we’re going to do is take a look that we should probably see what it’s actually costing us. So I’m going to pull up two future value calculators here, Cory.

5:18

Oh, and by the way, that 24 that they only need to make, like 100 grand a year to be in that 30% range if they lived in California and had that state tax plus the federal. So yeah, not Warren Buffett, just doing their time. And I think like, let’s say they’re in their 20s. They went the Mike Rowe road Dirty Jobs route and like went through a trade school got a job in a trade union. Well, they put in their 30 years, like they are probably up above that 100 grand range just from seniority and working their way up the ladder and engine their dollar dollar rate up. So this is not like a upwardly mobile go getter, even kind of person, just six pack from what we’re,

6:08

what we’re talking about is actually right now below what a fourth year electrician would make and a fourth year UPS driver. Okay? Again, we’re not talking about somebody going from lower income to, you know, Warren Buffett level, this is just good, solid work ethic in a household, and you might have a spouse’s income later on in life, adding to your income level. But let’s just see what the actual math is. So what we’re going to do is just look at the first $10,000, that first contribution, and that if we put that in, and it had 40 years to grow, so let’s just say it’s 25 year old putting the money in there taking it out as 65. It grows to $149,000. Now, Cory, could you do that? At a 12% tax rate for me, but don’t tell me the answer. So just tax this by 12% For me, or better yet go the other way? After tax of 12%. So times point eight, eight. Okay. But hold on to that for a moment.

7:22

Is it $131,775? That was really good. We didn’t plan that look good, though. So this is the point. That’s our after tax money invested? Because when we’re told this, that we’re going to have our money, co invested with the IRS, over 44 years, you’ll even hear people, people are tempting to be straight unethical. Would you say something like, well, you make money on the IRS as money.

7:51

But the IRS doesn’t pay you a fee for managing their money for them.

7:57

Yes, you. You are listening to this podcast right now. Because you’re trying to do better managing your investments. The IRS isn’t paying for us the IRS isn’t taking time out of their day to listen to us. The IRS isn’t paying us to be their financial advisor and coach you are. And they’re really happy that you’re being so responsible growing that IRA money. Let’s take it a step further. What happens? How much did we lose if we just retired in a 30% tax rate? And by the way, my point of all this is they have this fiduciary standard that relates to all of the investments somebody can be in. And yet zero fiduciary standard in doing what you will see is absolute robbery by the IRS. Now I should say it’s not robbery. People are doing it voluntarily but they’re wildly misinformed.

8:50

Okay, but the government has had a huge push for auto enrolment and auto escalation of 401k money and that’s goes to the traditional. So the government not imposing the same fiduciary standard on itself that they do any other. Oh, so you’re saying?

9:11

Are you telling me quarry that maybe this works out really well for the IRS is what our math is gonna tell us in a moment and the IRS and federal regulators are some of the biggest proponents that people put more and more money into this plan. Hmm. And the financial institution. The financial institution gets to manage both the IRS is money and the clients money.

9:37

Hmm, I think we should be like there might be some interest behind it. Yeah. Congress writes, The IRS has checks. Congress writes their rulebook and, you know, you know, politicians tend to have friends in lots of places so you and we’re not going blackbox kids Pharisee theory because it’s not a secret conspiracy.

10:03

I’m the conspiracy theory specialist here, guys. It’s black helicopter conspiracy theory, black box. And I apologize for Corey, he does not go as down as many rabbit holes as I’m willing to. I really

10:15

don’t. And I don’t apologize for not. But it’s not even a conspiracy because it’s not secret. It’s just, it’s right there. Like everyone. pretty aware this kind of thing

10:28

happens. Except nobody tells, like when we tell people, sophisticated people making lots of money, we’re often the first person that’s ever said to them, Well, you might retire in a lower or higher tax bracket than you’re putting this money in. And you can almost hear Record scratch in the conversation, because lo and behold, the financial institutions are not talking about it during the enrollment meetings. And the IRS isn’t telling you about this tax bomb that’s coming. So let’s go back to our screen and see the actual impact of what it looks like. If you put it in at 12. And then you were taxed at 30? Well,

11:01

as a as an intermediate step to that, can we talk about telling a 25 year old Oh, well put this money in your IRA. So you get the deduction or your your 401k? So you get the deduction? You’ll have more money in your pocket this year?

11:15

Oh, yeah, I don’t I we can do that. I wasn’t ready for it. But we can. Alright, well, we’ll see. I might, I might be able to whip that out for you. circle back. All right. So here we go. Here is remember we said the outcome would be if you retired the same tax rate, you’d have $131,000? Well, what happens if you don’t retire in as high or as good of a situation? Should say definitely, you retired a great situation, which is you have lots of income. The problem is yet now you’re in that 30% tax rate. So what we’re going to do, Cory, would you just do the math on this one contribution. For me, remember, this is just the first year grew to 149,000. This problem gets worse, if that person is making 4050 $60,000 a year for half a decade and has been putting it all in at that rate. So Cory, let’s just say it’s 30% tax rate, what is that person going to have going to have left?

12:19

At a out of the 149 745?

12:23

Yep. It’s just a 30% tax rate. So 70%,

12:29

yep, 104,008 21 and 50 cents,

12:33

okay, give me just a second, we’re gonna grab an interest rate calculator here, clear it out. And I’m going to start 10,000. Contribution, annual payment. In fact, I’m going to be really nice, I’m going to call it an $8,800 contribution, I’m even going to take into account the tax deduction on the front end. Future value was how much it could have 1048 to 158 to 1.5. And we’re also doing that over 40 years. So you see, what happened is, your rate of return on that contribution is now over half a percent lower for the entire 40 years. By the way, how low that rate of return looks gets worse. If we were to recount this in your 40s. Okay, so it gets worse. If you don’t have the arbitrage in your 40s either. Right?

13:38

Did I miss you in that when I was doing the math over there? You have a seven $7 for annual payment?

13:46

Oh, thank you shouldn’t have seven should have zero. But it does come out to the same for some reason, just such a small amount of money every year. Yep. So we give up rate of return the entire time. And oh, by the way, let’s say even higher taxes were the case. And let’s say you retired in California, where with state you’re at 50%. Well, now you’re down to a five and a half percent rate of return for the entire 40 years. That’s literally money we just handed over to the IRS. And not to mention 10s of 1000s of dollars more and we only assumed one year of contribution. Now to Korea’s point, and I’m going to do my best to kind of make this point a little bit unprepared with awful handwriting but everybody sit tight. We have somebody who is using 401k and somebody’s not using 401k This is your finances on 401k. There’s your finances, not on 401k

14:51

So $200,000 income and a 25% tax rate just to make it easy on our mental math.

14:58

Perfect. So we’ll say 100 Ricky and come up here. Yeah, good 401 K person puts $10,000 A year into the plan, not 401k person puts in 040 1k person now has a net income. Taxable, of $90,000, not 401k person has a taxable income of $100,000. Now, if they both have tax do of 25%, then the person with 100,000 They pay a tax bill of 25,000. And this person pays the tax bill, you can double check my math here, Cory, but I believe it’s 22,255 22 522. Oh, thank you. Yeah. Returning to five.

16:02

Thank you. All right.

16:05

So net income, what are they each have left with a person over here, as $67,500. That’s money leftover after taxes that they could spend any way they wanted. And the person on the right has $75,000 worth of net income. And the difference between these two, Cory is $7,500. So when somebody says, Hey, you put money into your 401 K, that means there’s more money on your balance sheet, you paid less in taxes. So you should be able to invest that. And the amount that they’re talking about is this difference here. But we have no extra cash flow from the tax deductibility of the 401k. There is no savings, tax savings to the 401k. There is only delay. So now as you’re looking at the screen, you may be wanting to like tax Korea or Iran now like well, where where’s the tax savings go? Because I did pay less in taxes. Where isn’t it is in the least, suspecting place. Because when you’re in a 25% tax bracket, and you put money in the plan $7,500 That day, is your money. And $2,500 is the money the IRS decided to forego and CO invest with you as a partner inside your 401 k. Now, of course you do things like watch this podcast is Cory was saying earlier, and you learn how to do better with your money and therefore get better returns, which is what the IRS wants. Because your tax savings is in the plan. And unlike a mortgage that will grow over time as your asset grows, kind of like a shadow, you cannot run StarCore

18:00

well, and we’ve never talked about it like this before, but I I said it earlier, like we you don’t get to charge the IRS and an a fee for investing there, you know, taking care of their money for them.

18:14

No, and if that doesn’t happen. And what’s worse is there’s trillions and trillions of dollars in retirement plans like this. And it is one act of Congress away one change of tax rates away from an enormous windfall to the IRS, at the cost of the people that have been the most responsible with their money. But even without that stroke of the pen, you could easily be putting money in at a 10% rate. And then unbeknownst to you, you’re actually planning to take it out at a higher tax rate. It’s just nobody told you. And so our push would be for anybody. If you’re a watcher of this podcast, you’re probably not in your 20s you’re probably higher income earning in your 40s 50s, etc. What I would do is recommend you send this episode to any young responsible person that you care about. just texted to him, you hit that little Share button. You could tag them in the comments tell us what you think about the episode. anyway to get this in their hands. So they get exposed the idea of like, wait a second, like for many people who are you know, full of vinegar and starting their career if you ask them like what what tax bracket you want to retire and they’re gonna say the top one. That’s their plan right now. Now they got a lot of work to do to get there. But if you’d like to retire one day with a lot of income, then don’t be making it part of your plan to just put money first into a tax deductible vehicle because we are making the irrevocable decision to both delay the tax and to delay the tax calculation, both of which could work against us. It’s not that 401 k’s are bad and nobody should ever do them. But it is important that we pull back some of the math. We look at something like this. And we look at the time value of money and what percentage that account is likely to be mine. Because as you get that next 401k statement in the mail right now, on the traditional side of your 401k, you go to our prior episodes, we covered the difference between the two really thoroughly, you get your 401 K statement, the melee might feel great, it looks like it’s got $400,000 in it, multiply it by point six, five, if you want it today, multiply by point five, five, because you also pay the 10% penalty. It is not all your money. And I think the second biggest disclosure, the government requires every single traditional 401k to have a potential tax liability right next to the amount of money to keep all investors present that they have a partner, which would both allow all of us to be much more interested, the government is very efficient with their dollars and allow more of us to keep more of our money by using the Roth option. As we all are most of you listening have the option in your 401k. Cory, I feel like I’m all rented out, I feel better and appreciate the therapy session. Anything else you want everybody left with?

21:00

No, I like that, you know, if you are listening, and you’re not the youngest person in the room, and most places that you live or go, there are cases where the 401k can be useful at the end of your career when you’re already at the highest tax bracket that you’re going to be. So just to reinforce it’s not that all this other 401 k’s are bad. It’s just when you’re very obviously on that far end of the spectrum. How can it be so a foregone conclusion that that’s where the money should go? I don’t think I think it should. So that’s my last disclaimer as head of compliance.

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And with that, and from all of us here sound financial group. We hope this has been a contribution to you being able to design and build a good life.

 

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