Retirement Planning Tips
Dirty Little Secrets About Your Retirement Accounts
It's bad enough that stock market gyrations of the last few years have severely reduced retirement account balances, but most people are not aware of non market factors that have made the situation worse. To add insult to injury, a majority of workers with 401(k)'s or traditional IRAs have not stopped to calculate the impact of fees and taxes.
Dirty Little Secret #1 – 401(k) Fees. In all the years that 401(k)s have been around, it was not until 2012 that a major effort was made to have administrators fully disclose the actual amount of 401K fees. Fees can be hidden in as many as a dozen different subcategories and even financially savvy investors have a very difficult time calculating the total amount of fees in any given plan. The differences in fees between different plans may seem small but their impact is huge. The smallest fees are generally found in government run plans such as the Thrift Savings Program for military and federal employees. Fees for the TSP can run as low as .025%.
401(k)'s for small businesses can have fees as high as 3%. This seemingly small spread could make a difference of as much as 40% in your ultimate investment results. For instance, if a worker invested $5000 a year for 40 years and averaged a 7% return they could end up with around an $875,000 balance if their 401(k) only charged .5% in fees. If that same worker invested the same amount for the same number of years in a 401(k) that charged 3% in fees his or her ultimate balance would be only $475,000. If you have a 401(k), don't wait another day to find out what fees you are actually paying. Disclosures were supposed to be provided to all employees by the second half of 2012. If you are still not sure what 401(k) fees you are paying, ask your employer.
Dirty Little Secret #2 – Taxes. Everyone has heard that one of the big advantages of tax-deferred retirement plans is that you pay no taxes in your younger years on your contributions when you're in a higher tax bracket, but when you withdraw the funds after age 59 ½, you will be in a lower tax bracket. Did you ever stop to analyze whether this will actually be true in your case? When you hit retirement age many of your biggest tax deductions will probably be gone. For instance:
- Your home may be paid off by then or in its final years of the mortgage, which drastically reduces or eliminates the impact of a home mortgage deduction.
- Your children will be grown and hopefully moved out of the house!
- You may have other sources of income after retirement that can place you in a higher tax bracket.
- If your income is too high your Social Security benefits will even be taxed in the early years.
Most people are familiar with the importance of diversification but usually only associate it with investing in different types of asset classes, such as stocks, bonds, real estate, or even perhaps precious metals. An equally important consideration is tax diversification.
Alternative #1 – When it comes to the tax treatment of retirement plans, there are three categories: tax deductible, tax-deferred, and tax-free. Unfortunately you can only ever receive two out of those three in any plan. A traditional 401(k) or IRA has tax-deductible contributions and will be tax-deferred but the withdrawals or distributions will never be tax-free. On the other hand, the contribution to Roth IRA's are not tax-deductible, the earnings grow tax-deferred, and the withdrawals or distributions are completely tax-free after age 59 ½. You also need to evaluate the fees on the underlying investment in any Roth IRA. A Roth IRA can be an excellent retirement vehicle, however contributions are limited and high income earners are not allowed to contribute at all to a Roth IRA.
Alternative #2 – The cash accumulation inside of some life insurance policies presents another viable option. Available cash maybe borrowed from a life insurance policy at any time regardless of your age. Since this is a loan rather than a withdrawal there are no tax consequences. Your cash accumulation may even be tied to stock market performance through the use of an equity index universal life policy (EIUL). These type policies have a cap on the amount of gains, but also put a floor on potential losses. The typical floor is 0% so if the stock market goes down your cash accumulation will not experience a loss. Some index universal life policies not only provide a death benefit and cash accumulation, but also, benefits payable if you become afflicted with a chronic, critical, or terminal illness.
Summary – Do your homework. Understand what you own, what fees you are paying, and what your future tax bills may be. Investigate all your options. Make sure you are diversified, not just among asset classes, but equally important for future tax consequences.