The Value of Tax Deferral


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Tax deferred account / qualified plan

Contributing your $3,000 to a 401(k) or other qualified plan, you have the whole amount to invest and investment earnings are tax free – but you have to pay tax when you withdraw it.  Leaving it in for, say, 20 years you would have $6,414 after paying your tax:  $3,000 x (1.06 ^ 20) x (1-.3333).

Taxable account

Contributing to a taxable account, you have $2,000 to invest after tax ($3,000 x (1-.3333)) and investment earnings are taxable so your effective investment return is 4% (6% x (1-.3333)).  But then you’re done paying taxes.  After 20 years you would have $4,382:  $2,000 x (1.04 ^ 20).

What if’s:  rising tax rates, capital gains, return, deferral period, Roth

In this simple example, the qualified plan clearly beats the taxable account.  But what if tax rates are higher at withdrawal?  For the $4,382 in the taxable account to beat the qualified plan, the tax rate would have to suddenly jump to 54.5% at withdrawal:  $3,000 x (1.06 ^ 20) x (1-.545) = $4,378.   Any tax increase that happens more gradually would be worse for the taxable account, with no effect on the qualified plan.

What about capital gains?  If the current 15% long term capital gains rate is sustainable and all your investments qualify, your effective return is 5.1% (6% x (1-.15)).  You still start with $2,000 to invest after tax, so after 20 years you would have $5,408:  $2,000 x (1.051 ^ 20).  That’s not bad, but it’s still less than the $6,414 you would have had from a qualified plan.

What about different investment returns and deferral periods?  We’ve used 6% return for 20 years in this simple example, but how does it change for other returns and time periods?  The short answer is that higher investment returns and longer deferral periods favor the qualified plan.  Lower returns and shorter time favor the taxable account.

What about a Roth IRA or 401(k)?  As it turns out, Roth and regular 401(k) results are identical if your marginal tax rates are equal at contribution and withdrawal.  Roth is better if your marginal rate at withdrawal is higher than at contribution time; otherwise a regular 401(k) is better.  And they both blow the taxable account out of the water.

These examples confirm the value of tax deferral in qualified retirement plans. As included in the examples the tax rate would have to increase to 54.5% at withdrawal to make tax deferral a bad deal. The Roth example is simple yet effective.

Please comment or call to discuss.

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Bill would remove penalty for tapping 401(k) to avoid foreclosure

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This must be the last recourse for employees. By relying on your retirement account for every emergency your retirement future will be in jeopardy. Responsibly borrowing must be a priority for all Americans.

The change would work like this: Under current rules, anyone making what’s known as a “hardship” early withdrawal of funds from their 401(k) must pay the IRSa 10% penalty on top of ordinary income taxes. A bill introduced Oct. 5 would waive the penalty if the purpose of the distribution is to make loan payments to avoid loss of a primary home to foreclosure.Co-written by Sen. Johnny Isakson and Rep. Tom Graves, both Republicans from Georgia, the bill would allow owners to pull out up to $50,000. The money could be used in a lump sum to pay down the delinquent mortgage balance or to fill shortfalls caused by reductions of household income. It could also be used as part of loan modification agreements with lenders designed to avert a foreclosure. No matter how the money is used to resolve the mortgage delinquency, it would need to be spent within 120 days of receipt and could not exceed 50% of the funds in the retirement account.

It must be understood that this bill only exempts the 10% penalty the taxpayer would be required to pay income tax on the withdrawal.

Please comment or call to discuss.

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Four ways starting a 401(k) can help your small business

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With all the talk of raising taxes many business owners are looking for ways to reduce taxes. Establishing a 401(k) for your business has benefits for both the owner and the employees. We must think long term to reach our financial goals.

Here are four ways a 401(k) can help you and your business:

  1. Tax-defer up to $49,000 from your own personal taxes this year! That’s right.  Every employee including the owner has the ability to contribute $16,500 a year tax-deferred in 2011 to his or her 401(k) account ($22,000 if you are 50+ years of age) plus receive employer match and/or profit sharing contributions up to the $49,000 limit ($55,500 if over 50).  The tax savings alone can help many business owners keep more of their own money versus not having a plan at all.
  2. Build a nest egg of a $1M or more in 25 years or less. Tax savings are big enough reason alone to start a plan, but when you combine high contribution amounts with compounded growth, your 401(k) can build to be a big financial asset.  An owner who earns $140,000 a year and contributes $16,500 a year and receives a four percent match (an additional $5,587 a year) into his 401(k) account could have $1,396,977 in 25 years.  This does assume a 7% annual return on the savings which of course could be more or less depending on markets and investment selections.  Regardless, it can be a meaningful amount.
  3. Save some serious money retaining and attracting top talent while helping your employees too. Great employees can switch jobs in good or bad economies.  Not too many things are worse for a business than losing a top employee with invaluable business knowledge and customer relationships.  Add in the costs of hiring, training, and ramping up a new hire and the actual costs are often two to four times greater than most expect.  401(k) plans are one area that small business can get an edge on big business and standout in the current business climate.

There is no better time to start or improve your company 401(k) plan than right now. Talented employees are becoming very difficult to find and retain. A well designed retirement plan for your employees can go along way in building your business.

Please comment or call to discuss how this would help your business grow.

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When is a 401k Distribution Not Subject to the 10% Penalty?

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When is a 401k Distribution Not Subject to the 10% Penalty?

There are only a couple of situations where the IRS will waive the 10% 401k early withdrawal penalty, i.e., a withdrawal prior to the participant reaching age 59½.

  • Amount of your unreimbursed medical expenses greater than 7.5% AGI ( IRC §72(t)(2)(B) ).
  • There is a Qualified domestic Relations Order (QDRO) from the courts that mandate funds from your account go to a former spouse, child, or dependent ( IRC §72(t)(2)(C) ).
  • You have separated from service and were at least 55 years of age when you did so (or separated from service in the year in which you turned 55) ( IRC §72(t)(2)(A)(v) and 72(t)(10) ).
  • You have elect a Section 72(t) distribution.
  • You are totally disabled. (The key to the disability exception seems to lie in the permanence of the condition, not the severity. Therefore, to claim this exemption you have to furnish not only information proving that you are totally disabled, but also information on the permanence of the disability.) ( IRC §72(t)(2)(A)(iii) )
  • You have died and your beneficiary gets the money ( IRC §72(t)(2)(A)(ii) ).
  • You have made contributions under special automatic enrollment rules that are withdrawn pursuant to your request within 90 days of enrollment ( IRC §414(w)(1)(B) ).
  • Certain distributions to qualified military reservists called to active duty (IRC §72(t)(2)(G) )
  • Because of an IRS levy of the plan ( IRC §72(t)(2)(A)(vii) )

It goes without saying that early withdrawal from your retirement plan should be your last resort.

Please comment or call to discuss.

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401(k) rip-offs: How to protect yourself

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The 401k was first established as a supplement to pension plans. It is now the primary resource for most Americans to successfully retire. We must begin to treat them as such.

There may be larcenous gremlins in your 401(k) eating your retirement money. They aren’t easy to identify and are often buried in plan documents. You will need a trained professional to exterminate them.Many of the biggest 401(k) money-eaters escape the notice of your employer, who is legally obligated to ferret them out. Your company may have bought 401(k) services from middlemen who suck up your money in the form of commissions, administrative or management fees.

How do you know if your money is being siphoned off? In many cases, you will never know, nor will your employer take the time to audit your plan to get rid of the worst abuses.

The U.S. Department of Labor is working on new rules that would make money managers connected to retirement plans fiduciaries. That would set a higher standard that would put your interests first.

The money trust is vigorously opposing these guidelines, which could potentially eliminate or curtail some of the worst skimming practices. Yet that may not have much impact if the Labor Department does little or no enforcement, which has been the case in the past.


Wall Street has used the 401(k) plans as a cash cow. It may be time to stop this and put more money in the accounts of the participants. Unless of course you believe Wall Street can use the money.

Please comment or call to discuss how benchmarking your plan would benefit you and your participants.

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Need to Catch Up on Retirement Savings?

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The events of the last few years have had a profound
effect on many executives, professional and business owner’s ability to retire
on schedule.  The market volatility may
have decimated their 401k and other retirement accounts.  Along with this problem there continues to be
a threat of increased taxes to pay for the deficits.

Enter the cash balance plan where pre tax contributions
can be as much as $220,000 per year plus your 401k and profit sharing
contributions.  The cash balance
contribution limit is based on the participant’s age.  Each principal participant is able to
determine their own level of contribution.

As a hybrid plan, the cash balance plan design includes
features of defined contribution (401k) and defined benefit (pension
plan).  They are best suited for
companies enjoying stable, high incomes.
The contribution levels must be continued for at least 2 to 3
years.  There is more flexibility than
the traditional defined benefit plan and there should be an analysis performed
to determine feasibility.

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