Joe Saver’s Story

Do we know how our IRA, 401(k), 403(b), 457 or SEP Qualified Retirement Plan really works?

Here is the story of Joe the Saver. When Joe was 30 years old on the advice of his Financial Advisor, he invested $6,000 a year in a Qualified Retirement Plan for 35 years. He earned 7.5% a year on his investments and at age 65 he had accumulated $1,000,000.
Joe was told by his Financial Advisor that one of the big advantages of a Qualified Retirement Plan would be the tax savings. He was in a 33.3% tax bracket; so, he saved $2,000 a year in taxes on the $6,000 he invested. Over the 35 years Joe saved $70,000 in taxes.
Now that Joe is retired he does not want to spend any of the $1,000,000 in his plan. He just wants to live off of the 7.5% interest of $75,000 a year it earns. At this time there are no longer any dependents at home and his mortgage is low or paid off; so, that means he is still in a 33.3% or higher tax bracket. He will pay taxes on the $75,000 of interest income at a rate of 33.3%, which is $25,000 leaving him $50,000 of net income to live on.
Remember the $70,000 Joe saved in taxes over the 35 years he invested in the plan? In 2.8 years he will pay taxes equal to the $70,000 it took him 35 years to save. ($70,000 divided by $25,000 equals 2.8 years). He will have to pay that $70,000 in taxes every 2.8 years. If he lives 20 years to age 85, he will have paid $500,000 in taxes versus the $70,000 in taxes it took him 35 years to save.
When he passes away, his spouse will pay $70,000 every 2.8. When the spouse passes away, their children will pay $70,000 every 2.8 years, plus 33% or more on the $1,000,000.

This is what FORBES magazine calls “The Tax-Deferral Trap”. (August 19, 2009)