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MONTHLY TAX NEWSLETTERApril 2008
Let me start out by stating that I don't hate Roth 401k and 403b accounts. That being said, the advice I consistently give my clients is that unless you're in one of the lowest tax brackets, you should avoid them like the plague.
Here's why. When you contribute money to a 401(k) plan or 403(b) plan at work through salary deferrals, the money you contribute reduces your taxable wages and grows tax-deferred. Let's say you're in the 35% federal tax bracket and live in a state with a 5% income tax. Assuming you max out your salary deferrals this year, you'll save $5,890 in taxes on your $15,500 of contributions. Invest that tax savings at 8% over thirty years, and this year's tax savings will grow to be worth $60k.
When you go with the Roth version of these plans, you voluntarily forego a tax break this year in exchange for a PROMISE from the government that you can make tax-free withdrawals from these accounts when you retire. Basically, the government is asking you to pay higher taxes this year, and then you or your heirs can access that money without paying even a dime in taxes, assuming the rules don't change at some point before you retire. Sounds pretty good, huh?
Hogwash I say. Yes, hogwash I say. I don't trust those guys in Washington one bit to keep this promise. Especially since twenty or thirty years down the road, it will be a whole different crew of politicians in Congress who will be tinkering with the tax rules that were put in place by the current crew of politicians. And if you remind them about the promise they made, they will simply remind you that it wasn't them who made the promise.
How can I say such a thing? Simple, because this exact scenario has happened before. Each week when you get paid, your employer withholds social security and Medicare taxes from your pay. Are you aware that you don't deduct the social security taxes you pay during the year? Yes, the money you pay into social security is post-tax dollars, just like the salary deferrals you contribute into your Roth 401(k) or 403(b).
Now, here's where things get a little scary for you lovers of the Roth 401(k) or 403(b) accounts. When social security was first enacted, any benefits received were not supposed to be taxable. Post-tax contributions and tax-free withdrawals. Does that ring a bell?
Well, at some point, the government needed money, so they made social security benefits up to 50% taxable. And then, in 1994, the government again needed money, so they made social security benefits up to 85% taxable. How confident can you be that the same exact thing won't happen with your Roth accounts? Actually, I'm fairly confident that they WILL find a way to somehow make Roths taxable in my lifetime. As a matter of fact, my brother and I did not bother to amend our firm's 401(k) plan to add the Roth option.
When I rant about Roth 401(k) and 403(b) accounts to my high income clients, some have called me a hypocrite since I also tell them to make a non-deductible IRA contribution in anticipation of converting that money to a Roth IRA in 2010. (You can read my article about the Re-Emergence of Non-Deductible IRAs on the March, 2007 newsletter.) But with that strategy, you're not giving up a current year tax deduction to be able to end up with some money in your Roth account.
My final thought is that our elected representatives in Washington are probably pretty proud of themselves for coming up with the Roth 401(k) or Roth 403(b). Every time a highly compensated person opts to go with the Roth version of these salary deferral plan, it's more money in the government coffers this year. And nothing puts a smile on a politician's face quite like that.
April 15th is right around the corner. If you think you might need to go on extension, here are some articles about extensions that we've posted in previous years:
Please note that these articles have not been updated since originally being posted.
How a Written Financial Plan Can be your Lifetime Financial Compass
Many people do not have a financial compass, and they are constantly blown around by the financial winds of the day. The winds come from many directions; the demands of our personal and business needs, wants, emergencies, the emotions of the stock and bond market, and from sales offers from a wide range of investment and insurance institutions. Because of the complexities of life and finances, some of the decisions we make may keep us from reaching our goals unless the decisions are weighed against an overriding plan.
Make 2008 the year to get a financial plan. Your plan will be the ’compass‘ that you refer to when making all financial decisions. A financial plan is your personal mission statement for your money. It's a centralized location to record all of your financial information, formulate your goals, your individual style of investing, and outline the steps you must take to reach your future goals.
Your financial plan should cover many areas including the following:
When you have a plan, and someone offers to sell you insurance, you can refer to your risk management section to determine your needs. If someone recommends an investment, or you are in a panic because of the stock market swing, then refer to your investment profile to remind you of your investment philosophy, how investments function over the long term and the overall make-up of your portfolio.
Before an impulsive purchase, refer to your plan to decide which of your other goals you are willing to delay. A financial plan will help you to determine where you will allocate additional money from a raise or bonus. It should be used as a reference guide before incurring new debt, spending emergency funds, and on and on.
Having a financial plan doesn’t control you, but becomes a tool you use to control your future. It is like a master plan for a house. As you build each room of the house you must refer to the master plan to make sure that each room is built with the correct proportions. In other words, you don’t want to end up with too much square footage in the laundry room and no room for a sofa and TV in the family room. Without a plan, you may be allocating too much square footage, for example to your ‘debt’ room and not enough to your ‘retirement room’. Your master plan should not be cast in stone. Perhaps the ‘house’ will need to have a ‘nursery’ room added. Your master plan should change as your life’s goals and priorities change.
Most written financial plans just sit on a shelf to gather dust after they are created. However, once you go through the time and effort of creating your plan, you should periodically refer back to your financial compass whenever faced with major financial planning decisions.
Kent E. Irwin is the President and Co-Founder of eFinplan, LLC, the first online comprehensive financial planning software for consumers. He is also a Chartered Financial Consultant (ChFC), a Chartered Advisor in Philanthropy (CAP) and a Chartered Life Underwriter (CLU). For help creating your Financial Compass, please visit www.eFinPlan.com.
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