Did you know you have a partner? Let’s see if you can guess his name. He is a relative. You know him well. In fact, every year we celebrate his birthday with fireworks. You probably know the answer by now but if you don’t, let me introduce you to your Uncle Sam.
Uncle Sam is your silent work and investment partner. He gets a piece of everything you ever earn from work or investments.
This means that every job you take and underlying every investment you make is subject to the reality of taxes. If you don’t understand the consequences of your choices, don’t worry, Uncle Sam doesn't mind, because he’ll tax you just the same come April. He is gracious that way and understands that many people don’t want to be bothered with learning ways to reduce their current taxes.
Uncle Sam recognizes many people find these tasks arcane and mundane. However, he also knows there are those that would rather keep more of their money today and use his benevolence of delaying the inevitable to their advantage. These are Uncle Sam’s high achievers, and he wants you to learn because it is a win-win situation. In the case of Uncle Sam, because he is eternal and never ages, he doesn’t mind you winning today; he will end up receiving even more taxable income at some far off future date.
For you, the learned, the high achiever, you get more money to spend at some far off future date as well, thus the title of this tale, How Can I Spend More Money in Retirement? This tale shows you some ways to be a good niece or nephew. Your reward is more money later and Uncle Sam’s reward is more tax revenue later. However, you will have to understand three key concepts to make this work for you and your silent partner.
Concept 1: Tax Rate of Return
As investors, our goal is to focus on our after tax rate of return. If you have a choice between two similar investments but one provides a better after tax rate of return than the other, a rational person should invest in the one with the higher after tax rate of return. In the words of Forrest Gump, “that’s all I have to say about this key concept.”
Concept 2: Taxable vs. Tax-Deferred
As investors, we must learn the difference between two terms. The first is the term taxable and the second is the term tax-deferred. After you read this tale you will understand why tax-deferred is better.
Concept 3: The Purpose of Money
As investors, we sometimes get confused about the purpose of money. We think more is always better and in most cases, it is. However, for most people, including myself, the purpose of money is not the amount accumulated but how much of the amount we can spend. In other words, the after tax amount that we can spend is what matters. This tale will answer your question, How can I spend more money in retirement? It gets easier if you understand a few simple things about taxes.
At this point, you are probably asking, "What does any of this have to do with a 401(k) or 403(b) or IRA or variable annuities?"
Don’t worry, it will all make sense soon. You see, all four of these saving vehicles have one thing in common: They all grow your money in a tax-deferred environment. What does this mean to you? If you take advantage of the features of these vehicles, you will have more money to spend in your retirement, and you get the added benefit of paying less in taxes today. We need to clean up a detail before we can tell a tale. We need to make sure that everyone understands the difference between taxable and tax-deferred.
Taxable means that the profits or income you make are taxable at the federal and state tax rate in the year you earn these profits or income. Said differently, if you make it this year you pay taxes on what you make this year. Tax-deferred means you can defer paying taxes to a later date.
But Which One Is Better?
Meet John and Jake.
John and Jake both work for the same company and are identical in every way, except that John decides he wants to take advantage of the tax-deferred retirement plan his employer offers. He wants to participate. Jake, on the other hand, doesn’t want to participate. He would rather grow his money in a taxable account.
Who’s the smarter of the two?
For this tale, we will assume the combined tax rate is 30 percent for both John and Jake. Let’s do a little math to illustrate the growth of $1 over 30 years in a plan that grows tax-deferred and compare it to $1 over 30 years that is taxable every year. The results are amazing.
If you assume a rate of return of 50 percent per year, the tax-deferred account grows to $191,751. The taxable account only grows to $14,440. The tax-deferred account is more than 13 times greater than the taxable account. Even if at the end of 30 years, you take all the money out of the tax-deferred account and pay the 30% tax you will have $134,226 or more than 9 times the taxable account. I recognize that the 50% assumption is extreme, but I use it to illustrate the point. Tax-deferred growth over time is better than taxable growth.
Why is it better? Because you don’t have a partner getting a piece of your profits until you start taking money out of the account. John is going to be a lot happier in retirement in my opinion. At least he’ll have more money to spend.
"But Wait, There's More!"
The amount that John contributes to his tax-deferred retirement plan has two added bonuses. The first bonus is universal. Uncle Sam lets you pay less tax today on the money your employer pays you. The second is not universal, though almost universal. It is an employee benefit where your employer will also contribute to your retirement plan if you do. It is a company match and can be significant. You put in a dollar; they match it with a dollar. You put in another dollar; they match it with another dollar.
Let’s translate it to the following - think of a company match as an immediate 100 percent rate of return on your contribution. What do these two bonuses mean precisely? Let’s go back to the case of John and Jake and assume they both earn $50,000 per year and each wants to save 10 percent or $5,000 per year.
I recognize that my CPA friends will frown on the next statement since they are far more precise than I am. However, this is a tale and we use tales to illustrate a point and teach a concept, so let’s assume the following tax rates apply...
When Jake goes to pay his taxes, he owes Uncle Sam 30 percent of $50,000 or $15,000. He gets to keep $35,000. Since he wants to save $5,000 per year in a taxable account, he has $30,000 to spend. John’s situation is different. His is better. When John goes to pay taxes, he owes Uncle Sam a little less than Jake owes Uncle Sam. Uncle Sam gives John a bonus for saving in a tax-deferred fashion. Uncle Sam only taxes John at 30 percent of $45,000 because John invested $5,000 in his employer’s tax-deferred retirement plan.
Please note, if you are saving in a variable annuity you get no tax deduction or bonus from Uncle Sam. Uncle Sam wants to encourage and reward this type of behavior. He wants you to save money under the umbrella of a retirement plan. John only pays $13,500 in taxes. He now has $45,000 less $13,500 or $31,500 to spend. He has $1,500 more to spend than John because John had to pay Uncle Sam the difference.
Let’s see what happens next and let’s assume there is no company match. Assume a $1 contribution over 30 years grows at 8% and once again, the tax rate is 30%. In the tax-deferred account, in Jake’s account, the dollar reaches $10.06 while the taxable account only grows to $5.93. The tax-deferred account is about 2 times greater than the taxable account. Even if Jake liquidated the tax-deferred account and paid the tax at the end of the 30-year period, it is worth $7.04 or almost 19 percent more than John’s taxable account. We reach the same conclusion that tax-deferred growth is better than taxable growth all other things being equal.
Let’s examine what we would do with our $10.06 that is in a tax-deferred account vs. the $5.93 in the taxable account if we wanted to convert the 8% per year that the account generates into an income stream. The $10.06 will give us about 56 cents per year to spend instead of 33 cents per year to spend from the taxable account. You have almost 70 percent more spending power if you grew your money in the tax-deferred account instead of the taxable account. I call this The Income Stream Effect. Again, tax-deferral is a good thing. Just do it. Make Uncle Sam your partner.
Is There a Downside?
Is there a downside to what Jake does? The answer is yes and no. The downside is that because he has invested the money in his retirement account, he doesn’t have penalty-free access to it in the event he wants it. As in things Zen, the upside is that because he has invested the money in his retirement account, he doesn’t have penalty-free access to it in the event he wants it. But what if Jake really needs it because he has an emergency?
Once again, the good Uncle is there to help him. Jake can always borrow from himself through his employer retirement plan if he needs to.