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Your Retirement Income — News Flash! You’ll Only Be Spending AFTER Tax Income

by Jeff Brown on October 11, 2012 · 8 comments

  
retirement

There comes a time when retirement becomes very real. In my experience most people begin gettin’ that twitch in their get-along the closer they get to 50. It’s not much later when it dawns on ‘em that their 401K just ain’t gettin’ it done. In fact, if at 50, their $500,000 401K never had another losing year, AND averaged an annual yield of 8%, they’d not like the results. (Before continuing, here’s a sobering fact: The average American male of 58, has far less than $100,000 in their 401K.)

“Whoa there, cowboy, they end up with almost $1.6 million! How are they not ecstatic?”

I answer that question multiple times weekly. What’s the 10 year treasury yielding this week, roughly 1.7%? Wow! Turn the music up and let’s party! That’s when all the bond geniuses come outa the woodwork sayin’ how much they can get buyin’ corporate bonds and the like. OK, let’s do that. The guys runnin’ your plan at work have been tellin’ you all along that in retirement you’ll be wantin’ to keep your risk at a minimum, which I’ve found to be true. Duh. They say to realistically expect a 4% return. Let’s use 5% and create an example.

5% of $1.6 million is just short of triple the 10 year treasury yield. Of course, anything yielding 3-5% on Wall Street now, carries with it a relatively higher risk. But since you’re happy with that, and the plan’s advisor gives you the nod, you’re good to go. That 5% yield will generate a retirement income of approximately $80,000 annually. But before you start with the cartwheels, remember, that’s a before tax figure. Before we start figuring the tax hit, let’s take a look at your life at retirement age, in this example it’ll be at 65. As I recently cracked during a phone conversation this week, ‘There’s no deduction for grandkids.” As do most folks, you enter retirement with a free ‘n clear home. No payments are excellent, but no payments mean no tax shelter either. The point is that every April 15th the IRS finds you completely naked when it comes to any real tax shelter. If you live in a high income tax state like California and a few others, that $80,000 is gonna get pounded. Let’s be quick about it and say you were able to salvage $60,000 when the smoke cleared, counting state and fed taxes.

Before continuing, let’s review.

You spent 30-40 years building up your 401k to $1.6 million. (You’re not gonna, but we’ll say ya will.) Along the way you were happy to benefit from the tax savings, usually somewhere in the $500 to $5,000 range per year. Let’s say you opened your 401k in 1981, and will retire next week — about 31 years. Let’s say the tax savings over those years adds up to $100,000, give or take. There was a lotta sacrificing, as you gave up new cars for used, cheaper vacations for the ones you wanted to take, and the like. Your discipline was awesome. Yet after merely five years in retirement, you’ve already paid as much in taxes on your retirement income as you save in 31 years. Here’s the question I ask people about this fact of life.

Why would anyone do that to themselves on purpose?

Don’t get me wrong, as I’m not pooh-poohing an after tax retirement income of $60,000 a year. However, I’m not sure most would smile appreciatively at that figure, if they were initially told they’d managed to accumulate $1.6 million, do you? Here’s what the Wall Streeters won’t tell ya. The reason they advise against so-called ‘alternative’ investments (what a transparent crock that is), is simple: All the ‘alternative’ investments don’t reside on their shelves. Funny how that works, isn’t it? If they have it to sell, it’s prudent. If not? It’s (vampire music in background) ‘alternative’. I know what you’re thinkin’. “Fine, Jeff, you’ve knocked it down, we get your point. But what’s your solution?”

If you can — take control now.

There are Americans all over the country who’ve figured out that by taking the tax hit — which is freakin’ horrific — on their 401K today, it allows them to create a tax free retirement income for tomorrow. This isn’t true if your 401K is at your current employer. But 10s of thousands have old 401s they’ve allowed to sit and gather dust. Or they have IRAs. There are a few other entities you can mess with at your discretion. These people are deciding to do one of three things, sometimes a little of all three, simultaneously.

They ‘gut’ their traditional pre-tax contribution based 401/IRA and pay the taxes, and sometimes a 10% penalty to boot. Then they decide what strategy(s) they’ll embrace.

1. They then open up a Roth type plan. Which kind depends upon individual circumstances.

2. They get an EIUL started — using the money they previously earmarked for pre-tax contributions. (Search BP for EIUL)

3. They take all/some of the after tax money and invest in real estate.

This AIN’T one size fits all.

I’m gonna limit this post to concept for now. The concept is to create as much after tax, or better yet, tax free retirement income as you can. What so many are discovering too late, is what they always knew: We don’t spend pre-tax income — we spend what’s left. Income from investments inside a Roth ‘envelope’ come to you tax free in retirement. What this means in real life is beyond simple. But it boils down to two pivotal facts.

First, since you’re in control of what you choose as your Roth investment vehicle(s), you’ll probably be like the vast majority who’ve already learned they can easily out produce their ‘job’ related 401k without taking stoopid risks. In many instances they’re slaughtering the pathetic returns. Pathetic? How about the last 20 years? 3.5% is the average annual return generated by employer related 401k plans. Impressive, no? Um, no. Raise your hand if you think you can double that return using ‘alternative’ investments while napping. :)

Second, even beginning with 50-60% of your original balance — remember, you paid major league taxes when you bit the bullet to pull this off —  you’ll be able to create a tax free income equal to, or likely higher than if you’d retained the status quo. But wait, there’s more.

The income inside your Roth and/or your EIUL is tax free. Here’s what that means. If you merely equaled the $80,000 earned by the aforementioned $1.6 million, it’s now all ‘after’ tax money. In other words, that tax free $80,000 is the rough equivalent of over $100,000 in taxable income. To create 100 grand a year in taxable income inside your current traditional 401K — using the generous 5% we used above — means you’d hafta have garnered $2 million, NOT a ‘mere’ $1.6 million.

Beginning to see a trend here?

Again, just concept today. I plan to talk seriously and publicly about this subject after the first of the year. But I will tell ya that there are literally thousands and thousands of Americans who, if they can take a step back to objectively analyze what’s really happening to their retirement, instead of for their retirement, a light will go on. The difference can, and often is ginormous in scope. How would you like, in addition to your personal real estate portfolio, to generate five figures monthly — tax free — in retirement? Is it easy? Gimme a break. Nothing’s easy in this world. Everything we do in the investment world carries with it commensurate risk. That’s why they call it risk capital. But I do it. I counsel my own kids to do it. They paid the taxes and never looked back.

Retirement is all about what’s left after Uncle is done with us. The rest is HappyTalk.

Photo: kirybabe

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{ 8 comments… read them below or add one }

Dale Osborn October 11, 2012 at 10:11 am

Great article on those with 401ks, hopefully some others will see the light and follow your advice to change things around. Big Brother is just drooling as it waits to get all the tax revenues deferred over the years. Pay now and be done with the whole problem and the rebuild the right way.

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Jeff Brown October 11, 2012 at 10:14 am

Thanks so much for the support, Dale. To some of us it’s one of life’s no-brainers. The facts speak for themselves.

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Jack Knochel October 11, 2012 at 6:40 pm

Great article Jeff. I am still trying to get mama onboard with this thinking, since it was her 401k that is now in a self directed traditional ira. THANKS for the chat the other day and can’t wait to read your upcoming articles.

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Jeff Brown October 11, 2012 at 6:42 pm

Much appreciated, Jack. Our chat was my fix for the day.

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Susan October 12, 2012 at 2:01 am

Thanks for this timely article Jeff. I recently left my job and have been looking into rolling my 401k into a self directed IRA and recently had the thought of cashing out for more flexibility. The possibly of doing a roth conversion which will be a much better option. Your article prompted me to review the rules something I hadn’t done since the Roth was first introduced. From what I can see the converted amount is taxed but the penalty is avoided. In addition the income limits for contribution are much higher than I remembered. The only restriction appears to be a 5 year holding period on pulling out earnings. This is a great strategy for investors rolling money in a self directed IRA!

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Terry October 12, 2012 at 11:49 am

Actually, I would be ecstatic if I had as much as $100,000 in my 401(k).

I’m a boomer with no retirement funds whatsoever. And it’s not as if I lived on an extended spending spree; the most I have earned in a year is $17K, with the average (in today’s dollars) not more than $15K.

The good news is that when you’re in the 10 percent marginal bracket, the tax bite isn’t as egregious as it is at, say, 28 percent. But the rent bite is horrific.

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Dennis October 15, 2012 at 6:24 am

I just want to add, you can transition your IRA to a Roth IRA immediately but the IRS will allow you to pay the taxes over a two year period of time. Knowing you are going to take an extra hit on the tax side for the following two years you might want to adjust your earned income for those two years. If not at least make sure you have some extra cash reserves to send off to Uncle Sam because you are not allowed to pay the taxes out of your new Roth IRA account.

The Roth IRA is a powerful vehicle, as I mentioned in another post I am selling short stock options inside my IRA to generate income. There is also a means to create a Llc that is owned by your IRA of which you control the check book directly allowing you to buy REI and other assets without the use of a director in a self directed IRA. There are companies that for a fee will make this happen. With this form of self directed IRA you can directly manage your REI in an IRA vehicle. Google Unleash your IRA, this is not a commercial I have no affiliation with any IRA company, this is FYI only.

You are going to be very happy when our government has to raise taxes to recoup those trillions of dollars they pumped into the economy with higher taxes and interest rates.

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Jeff Brown October 15, 2012 at 9:39 am

Thanks Dennis — An excellent summary. One of the things investors may wanna consider, when it comes when they pay their taxes is important. That is, what is their opinion of what tax rates might be next year vs this year. Will they be higher? Lower? It’s happens less frequently, but sometimes investors choose to pay everything in a year in which they think tax rates will be more attractive.

I love what you said about the use of LLC and self-direction. It’s something my teams expert on the subject has counseled for many. Thanks again, Dennis.

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