There are three major advantages of typical retirement plans. We went over many of the different types of these yesterday and they basically all work the same. The possible advantages that they give you are the following:
- Deferred Income Tax
- Your Contributions through an Employer sponsored plan might be matched
- Government mandated & penalized discipline to keep saved money saved
- Your anger of poor results is assuaged by the fact that everyone else is doing it
Let’s look at each of these.
What is the benefit of deferring income tax? It’s important that you understand that deferring income tax is not the same thing as avoiding income tax. These taxes must be paid some day, this vehicle simply allows you to put off the pain of paying the taxes until some point in the future. The benefit could be that if your tax rate is lower in the future, then you would have deducted the income from your taxes in a higher bracket. You would then pay the taxes when you’re in a lower bracket.
Of course, the opposite is true too. If you are in a higher tax bracket in the future, then this would have been a bad move because you would have deferred taxes in a lower bracket only to pay them later in a higher bracket.
If you feel confident that taxes will be substantially lower in the future, then this might be a beneficial plan for you. Or if you simply plan to be really poor in the future, then this could also be a good plan. Because the income tax code calls for a progressive, marginal tax that gets higher and higher the more that you make, one of the ideas behind deferring taxes is that you will be poor in your old age and thus be in a lower tax bracket. So if the tax brackets don’t change, and you have a low enough income (which would include money generated by assets, social security, and pulled from these accounts) in retirement, you might pay less in taxes when you pull the money out because of the lower bracket that you are in.
Another common reason to participate in these plans is to receive a company paid match to your contribution. Some companies offer this and it can be paid in any number of ways. For example, your employer might match the first 6% of your contributions at 50 cents on the dollar. In this case, if you contributed 6% to your 401K, they would contribute 3%. This gives you additional income (with taxation deferred) that you would otherwise not get. This can be a good reason to participate in these plans. One thing to be aware of, though, is that although you receive an immediate match to your contribution, all the other disadvantages still apply. So you should make this decision macro-economically based upon how it fits with everything else that you are doing.
Finally, because you have to pay a penalty to access this money before you turn 59 ½, plus taxes, you are less likely to dip into these funds and spend them after you have already determined to save them. So, if you do not have the discipline to keep true to a plan of stewardship and savings, the government adds extra incentive for you to stay true to this plan!
This last one may seem like a joke, but we think it’s a real benefit. When you lose money going out on your own and making your own investing decisions, it can be really lonely (of course, when you make money this way, you really feel blessed!). When you’re losing money in your government plan (which is probably invested in mutual funds), everyone else is losing money too, so you don’t feel as personally responsible for the poor stewardship of your money. This is a real benefit that you get with these plans – one you must be willing to walk away from if you take control of your assets.
We’ll spend the next several days discussing the disadvantages to these government retirement plans.
This is _Part 11_ in the series titled The Trunk. To continue with this series, click on Pt 12. To use this as a growth tool, please read Pt 1, Pt 2, Pt 3, Pt 4, Pt 5, Pt 6, Pt 7, Pt 8, Pt 9 and Pt 10.
Photo credit: Jeremy Brooks