By Professor Ricardo Ulivi, Ph.D.
When I started in the financial services industry about 34 years ago, the first dogma we were taught was to persuade our clients to invest in tax deferred accounts like IRAs, 401 (k), 403 (b) and so on. The justification was that, in your working years, you were in a higher tax bracket than at retirement, so it made a lot of sense to defer your income until your bracket would be lower.
I will illustrate how this scheme was SUPPOSED to work using simple math. (If you are a tax preparer, don’t yell!) Assume I made $100,000 when I was 40 years old, and I was in the 30% tax bracket. This meant I was going to pay $30,000 in taxes (30% of $100,000 to keep things simple). However, if I put $20,000 of my salary into a 401K I reduced my taxable income to $80,000. Thus, my taxes would now be lower, or $24,000 (30% of $80,000). In other words, by putting money into a 401 K I lowered my taxes by $6,000. Cool–at least that was the hook. At retirement, the story went, I would be in a lower tax bracket, say 20%, and so when I drew those $20,000 out of my 401 K, I would pay $4,000 in taxes.
Where’s the tax savings? To recap, I saved $6,000 in taxes when I was 40, but now I will pay $4,000, which means I saved $2,000 in income taxes in the long run. That, we were told, is a very good deal and so it seemed. So I became a sucker, as well as hundreds of thousands (and why not millions?) of other upper middle income people. Why?
What went wrong?
Let’s analyze my current situation and contrast it to my younger years. In 2013 I paid more in income taxes than I ever have. How much more? About two to twenty times more, depending on the year you use as a comparison. It’s horrible. And it’s not that my income has gone up that much . . . it’s just that my taxes have gone up disproportionately. What happened?
Let’s review some of the events that led to my current situation. My wife and I raised four kids; therefore, we were entitled to four exemptions. Because we did a good job raising them, they no longer depend on us financially. Thus, we cannot claim them as dependents. Today, each exemption is worth $3,900 which means we lost $15,600 in deductions. This alone increases my income taxes by, let’s say, one third or $5,200. Ouch. An empty nest sucks from a tax viewpoint!
When we were young and vigorous, we bought a big house and took a big mortgage at 12% interest. Assuming we took out a 30 year loan for $300,000 back then, we were getting a mortgage interest deduction of $36,000 or so the first year (12% times $300,000), which resulted in a tax savings of, let’s say, one third or $12,000. Today, my house is paid for, so I no longer have any interest expense to write off. That has increased my taxes by, let’s say, another $10,000. Ouch again.
So far, using these two simple examples, my taxes have gone up by $15,200. What happened to that myth that my taxes were going to be lower at retirement? But there’s more. My wife and I own some investment real estate. We were always highly leveraged, so all the properties would result in taxable losses, which SAVED us money in income taxes. However, now that we are close to retirement, many of our loans have been paid off, which means we no longer have rental losses but rental income. This means we no longer get tax savings from real estate; instead we get TAXED. Because of this, my taxes have gone up another $15,000 or so.
It keeps getting worse
Every year our real estate property taxes go up by 2%. Year to year it’s no big deal, but when you have owned property for 30 years or more, the inching up of taxes is a BIG deal. Thirty years compounded annually at 2% results in an 81% increase in property taxes!
Did I mention another of the disadvantages of owning real estate and getting close to retirement? Your property gets fully depreciated, so you can no longer take an annual depreciation expense. What does this mean? Your taxes go up, in my case by another $6,000 or more, because I have lost tens of thousands of annual tax write-offs due to depreciation expense.
Here’s more. We are still leveraging some real estate, but this strategy is not as effective for taxes as it used to be. For example, let’s say that my wife and I had a million dollars in outstanding loans at an average 9% interest rate back then. As a result of the crisis of 2008-09, interest rates plunged and we were able to refinance loans, so that our average interest rate today is 4%. That’s the good news. The bad news is that, because our interest expense has been cut by $50,000 or so per year, our income taxes have gone up by another $15,000. Another ouch.
The myth of a lower tax rate at retirement got blown away
My income taxes today are more than twice what my SALARY was when I started teaching full time at the California State University, in 1980. My income tax rate today is higher than it ever was in my career. Thus, using the strategy of investing in tax deferred vehicles, such as 401Ks and IRAs, as a way to defer income and pay less in taxes when I withdrew the money in retirement turned out to be a big fiasco. Why? Because the assumption that I would be in a lower tax bracket when I retired has turned out to be totally erroneous–at least for those of us who have managed our finances successfully.
My cynical side suspects that the so-called “advantage of saving in tax deferred vehicles” is a very good scheme perpetrated by the financial services industry to get us to save in their vehicles, so they could profit from our investments! “A sucker is born every day” . . . said PT Barnum, and how astute he was!
Based on my experience, here’s a warning to the young folks: before you rush to fund your IRA or other vehicle before the April 15 deadline, keep in mind that there might be better alternatives for your money. The advantages of tax deferral might be a mirage, so consider other alternatives uses for your hard earned money.
I’ve got to lower my taxes, so here’s a special invitation just for you. If you were a victim of this tax deferral scheme too, I invite you to drink a beer with me at my local watering hole. We can share our stories and cry together. But, the good news is that I may be able to write off the beer I buy you as a tax deductible expense, so inviting you may help me lower my taxes. Take advantage of this invitation; you get to spend time with me and you help me lower my taxes!
As usual, if you have a friend who needs help with retirement planning, I would appreciate it if you recommend my services. Ask them to call me at 714.771.6000 or just reply to this email.