About the value of Tax-Qualified Plan Wrappers.

About Tax-Qualified Plan Wrappers

Unique Investment Strategy Comparing Software that Performs Tax-qualified Math
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About Tax-deferred Investing in the 21st Century

With today's low dividend, capital gains, and ordinary income tax rates, there's not that big of a difference between tax-qualified and non-qualified investing.

The five methods of tax-qualified investing (AKA tax wrappers) this applies to are:

• The traditional: IRA, 401(k), 403(b), and 457 plans

• Roth: IRA, 401(k), and similar plans

Whole life insurance (AKA VUL)

Fixed annuities and variable annuities

529 college savings plans

Tax wrappers worked great back in the 20th century, when tax rates were much higher, but not when they are as low as they are now.

There are only three main factors in this equation:

• Tax rates on the three taxable events

• The average total rate of return driving the taxable events

• The actual taxable events themselves

If you lower these tax rates, eventually there will be a crossover point at which this will happen. For example if taxes were 0%, then the value of tax wrappers would be zero too.

Taxes are not 0%, so the level of taxable events (dividends, capital gains, and then ordinary income taxes on withdrawals) then becomes dependent on the average rate of return, combined with how the investment portfolio is set up (which determines basis, and how much dividends and capital gains you're realize).

For example, if a portfolio is 100% in equities, then there will be little-to-no dividends. If it's 100% in fixed income, then you'll realize little-to-no capital gains. If it's 100% in cash, then you'll realize 100% return of non-taxable basis when you make withdrawals.

If you made 0% long-term, then there would be no dividend or capital gains, and all withdrawals would be return of tax-free basis. So again, no taxable events mean no taxes to pay, thus there's no need for the wrapper (and their restrictions - like not being to withdraw money until age 60, having to take minimum distributions at age 71, students not being able to spend 529 money on computers, etc.).

The math shows that when the rate of return is below 10%, then tax-qualified investing only makes long-term money last a year or a few longer. That matters, but it's not the huge difference it was when tax rates were higher.

It's just as simple as that, once you have the investment calculator that performs this math, given various inputs.

The way to check the math, without buying the investment software, is to download the free demo, and then analyze the numbers on the calculation sheets. If you don't find any errors, then this is just the way it is.

Here it is:

Investment strategy comparison software demo

Once you "do the math," you'll see that the combination of the tax benefits not being worth it, fees and expenses and commissions, lack of decent investment options in captive plans (like 401ks and 529 plans), and the usual Wall Street shenanigans; makes all tax-deferred investing nowhere near the problem-solving creations everyone says they are.

Tax-deferred (qualified) retirement plans were awesome and essential back in the Stone Age when there were no viable DIY investment platform choices. In other words, before the advent of Charles Schwab in the late 80's.

But the advent of efficient discount brokers, combined with major economic sea changes, have rendered them all obsolete in many ways.

Then it's not the market going up an average of 10% annually that matters, it's how much your total account went up. When was the last time your 401(k) plan, variable annuity, whole life insurance policy, or 529 account made over 11% more than three years in a row? It was back in the last century, huh? When was the last time your taxes were so high that you were desperate for any kind of deduction? Also back in the last century.

Once you can get over all of the usual financial brainwashing, then you'll see you don't even need to invest in your company's 401(k) plan (or 529 or any life insurance company product).

Unless and until tax rates go up significantly, and/or investment markets average more than 12% a year (instead of being up double-digits one-year and then down double-digits the next, making the average be much less than 10%), then your life could be much better by ignoring the whole 401k plan debacle altogether.

There's no law or rule saying that you have to have money deducted from your paycheck to fund a 401(k) plan. Even if you're captive, you can stop contributing to it at any time and open up a discount brokerage account, and divert your new retirement savings all to that.

Keep in mind that most all of these tax-qualified (deferred) retirement plans were set up by the government way back in the Stone Age (70's & 80's). This was when stock markets were averaging 15% annually, 3% GDP growth was considered a bad year, government bonds yielded between 5% and 10%, the highest marginal tax rate on ordinary income was ~70%, just about the only way to invest was to pay a full-service stockbroker over 5% commission to buy a stock or a mutual fund, and inflation was averaging 4% to 8% annually. Also, when a high-earner retired, their marginal tax bracket on ordinary income was usually cut in half.

Back in the good 'ol days, the big problems were working too much and earning too much money and then having way too much of it going to paying taxes. Then barely making enough profit after accounting for taxes and inflation made it rarely worth investing in the first place.

The combination of all of these economic factors made investing in tax-qualified retirement plans a basic necessity of life. The main benefit of tax-deferred investing for retirement was that you got huge essential immediate tax deductions when your tax rate was uber-high (because you were easily earning tons of money).

Then when you retired, your tax rate went down - way down. So the repayment of these deferred taxes at retirement usually resulted in paying back much less in taxes than you saved along the way, sometimes even less than half as much. For the investor, this was one of the best deals the government ever created. For the Treasury, not so much.

But in this century, ALL of that has been totally reversed.

The big problem now is not being able to earn enough money even if you want to be a workaholic. Then when you invest, you earn little-to-no income yield, and most of your equity profits vanish as soon as there's another round of "self-inflicted government crisis."

The highest marginal tax rate on ordinary income now is not even 40% (or around 43% less). So when high-earners retire, their marginal tax brackets on ordinary income are usually only about 10% less than when working (compared to the last century when it could be almost cut in half).

Next the costs of buying a stock or mutual fund are so low it's essentially free, GDP over 3% would be considered a miracle, inflation will be hard pressed to be even 3% in one-year let alone two years in a row, and bonds don't even yield more than inflation (AKA negative real interest rates).

Next, the "horrendous amount of taxes" you'll pay annually in a non-qualified account is vastly overblown by everyone in the system too. Back in the good 'old days, a balanced investment portfolio yielded about 7%, and if you wanted, you could fairly easily realize 10%.

Now it's less than 3%, and you'll have to struggle hard to get over 5%, if that's your goal.

So right off the bat, taxes on dividend distributions are less than half of what they used to be. Then tax rates on dividends are less than they were back in the good 'ol days too.

Then there are capital gains taxes. When was the last time you were shocked by getting a surprise huge non-realized capital gains distribution from your mutual fund, resulting in having to pay through the nose in "phantom capital gains taxes?"

The answer is 1999. After that, these distributions have shrunken well below half of what they were. Then tax rates on capital gains are much less now too.

Here's some numbers:

Assume a $100,000 non-tax-qualified account yielding 2% with 1% in realized capital gains. At a 15% capital gains tax rate, you'd pay 15% of $1,000, or $150. You'd also pay 15% of $2,000 on the dividends, or a whole $300. Combined, this $350 is a combined tax of a whopping 0.35%. So as you can see, it's not significant anymore.

So as you can see, everyone that says to never invest retirement funds without the usual tax wrappers are just perpetuating ancient financial myths that have nothing to do with our current reality. They're living in the past, and just refuse to wake up and deal pragmatically with our new reality - which may be permanent.

When actual facts, logic, and math are used to evaluate these sea changes, the bottom line is that most all of the advantages of investing in any tax-deferral wrapper are mostly negated these days (and yes, this applies to all forms of whole life insurance and all forms of annuities too).

These days, the amount of taxes saved during the accumulation / deferral phase is so close to the amount of taxes repaid during the distribution / retirement phase, that's there's hardly any difference. But it's a night and day difference between the two century's scenarios.

So the old wives tale that you need to use tax-qualified retirement plans because "you'll get huge tax deductions now and then you'll be in a much lower tax bracket when you retire, so this deal will save you tons in taxes" - is very much over.

Things change, and so should the way you manage your money, and your life in general, if you want to survive it all long-term.

Now if you're asking yourself why this is the first time you've ever heard of such things, here's the deal: The system (Wall Street) couldn't care less about you. The system exists solely to feed the system. Whenever there's "change," the system makes less money. So the system works best for the system when there are no changes. Updating the whole way Americans' invest to account for this "New Economy" would be devastating to the feeding of the system. So most everyone in the system is happy to just plod along using outdated and totally wrong methods of doing most everything, because that's how they make the most money and are able to do the least amount of work. So most everyone will refuse to perform actual math, ignore logic and facts, and will adamantly continue to spew the same obsolete incorrect investing hype for decades to come.

It's just the basic human condition that everyone hates all of the tedious work that comes with analyzing facts, using logic over emotion, then using arduous math to discover how things actually work in the Real World. This is a theme of this site, so that's why all of these financial myths are only bunked here.

The system very much does not want you to DIY, so that's why everything it says is all about having everything stay the same. So when it comes to 401(k)s, the system very much wants you to contribute all you can while captive, then buy only one fixed annuity with all your money when you retire.

This huge and complex arcane mystery is now solved once and for all.

Some people have caught on to the new reality of low tax rates coupled with low returns, and how that negates the advantages of traditional tax wrappers. This is why Roth IRAs and 401(k)s became popular all of a sudden. But as you can see in the demos that do this math, Roths end up making less money over the long-term than traditional tax-wrappers. So being captive via Roth doesn't get around the new century's math either. So they were a current fad for a while, and then faded.

If you DIY, then you can also say goodbye forever to all of the restrictive rules and regulations governing: Maximum annual contributions, and not being able to withdraw money when it's needed for life's emergencies without taking a huge tax hit combined with a 10% tax penalty if you're not yet age 60 (or deal with annoying paperwork when you give yourself a loan). Then if you don't need the money after you're age 70½, you can just let it sit forever without anyone forcing you to take withdrawals from it (AKA required minimum distributions, MRD, RMD, or MDIB rules). All of these annoyances mostly go away if you can escape, and all of them never even appear if you can avoid being held captive in the first place.

All you'll need to do is pay much less than everyone thinks in dividend and capital gains taxes annually, and your money is free to do anything you need to do with it at any time. Other than taxing dividends, interest, and capital gains, the IRS and state tax boards can't say or do anything about it, ever. Plus, if there's an annual loss, you can write that off and/or carry it forward (which is something you cannot do in a qualified plan - you're taxed both on gains and losses equally).

So if your employer is not matching your contributions (if they're not giving you free money), then more than likely, you'll do better by not investing in their 401k plan at all (even if it's a Roth 401k). Just use a regular non-tax-qualified discount brokerage account for all of your savings and investing.

Again, if you think that's nuts because of all of the taxes you'd pay on dividends and capital gains, then losing the tax deductions on contributions - then you've just been brainwashed by the usual ancient financial services industry hype, and haven't done your math homework yet.

So another bottom line is this - if your employer is matching your contributions, essentially giving you free money, then you should do whatever you can to maximize all of that. Free money is free money, so you should take all you can get. But you should do some math first to see if their free money is actually more than all of the combined fees, commissions, expenses, and charges of the 401k plan. If you're paying $1,000 a year in feeding the system, and the company is only giving you $900 of free money, then you'll have a tougher call to make (because you're actually losing money on that deal every year).

21st century economic reality makes it so few employers give out this free matching money anymore. Even if they do, it's a tiny pittance compared to how much employers were compensating employees back in the good 'ol days with actual defined benefit pension plans for retirement.

So if this is the case, then if you have more than the few brain cells required to manage your own investments, then you'll most always do much better long-term by avoiding playing the whole tax-qualified retirement plan investing game, and just DIY with a non-qualified discount brokerage account.

A 401k plan is just a tax wrapper covering a lame investment management platform. The purpose of the traditional 401(k) tax wrapper is to entice you to contribute to it, with both saving taxes on contributions, and then not having to pay dividend and capital gains taxes annually. Roth 401(k)s are a different story when it comes to taxes, but it's the same deal for everything else.

But little-to-nothing is free in life, so the IRS gets all of this money back in one way or another when you retire. So when you start withdrawing money for your retirement paycheck, 100% of it is taxable at your highest ordinary marginal income tax bracket.

So there is no free lunch here either, just the opposite. This is why they're called "tax-deferred accounts." You are not saving, evading, or avoiding paying any taxes - you're just putting off having to pay them until later. You can't even avoid these taxes by refusing to withdraw money, because once you reach the age of 71, the IRS requires you to withdraw money (or they'll tack on stiff penalties if they have to make forced withdrawals for you).

So the only way to not pay back the taxes you saved along the way is to die. Then whomever is the beneficiary of your 401(k) will be stuck paying these taxes - also at their highest marginal ordinary income tax rates on 100% of the forced income stream for life. So in a way, 401k captivity doesn't even end when you roll it over into an IRA, or even when you die. Once you're captured, then you're subject to the system's whims for life (just like buying an annuity).

These Bottom Lines Applied to 529 College Plans:

The math bottom line is that all you'll have to do is get between 1% and 2% more average annual investment return in a non-529 do-it-yourself discount brokerage account, and you'll probably end up having more spendable money for college (which is the point of all of this), even after the 529 tax breaks. Download the demo and see for yourself.

The lower market returns are in general, the lower this difference is. If the stock markets only average 6% annually, then this delta (between 529 & DIY) is ~2%.

If averages more than 8%, then this delta would grow to ~3%. It's around 1% to 2% with average annual portfolio returns between 6% and 7%. With average long-term equity returns around 2% to 5%, you'd only need to get less than 0.5% more total return in a non-529 to beat the 529 plan. Total charges, fees, and expenses are usually much more than that in even the very best Vanguard Index fund 529 plans.

As you can see on this demo download, our $20k minimum no-load mutual fund models consistently do better than this 1% to 2% delta over what the average 529 plan returns. If you were to buy our investing models, then do this, then you'd more than likely get this 1% to 2% delta without even trying very hard.

Our unique college saving calculator is the one and only financial plan software tool that actually does this math. Because of these low equity returns, this 1% to 2% difference is also about the same delta needed to win long-term over all traditional forms of IRAs, Roth IRAs, unmatched 401(k)s, and of course all forms of whole life insurance and all forms of annuities.

This is all because when it comes to the distribution phase, the vast majority of the withdrawals come from basis (return of the original money you invested), and not "profit" (AKA unrealized capital gains). These distributions amounts are not taxed at all. This is so even at the highest tax rates.

Now, if your lights are turned on, you're correctly thinking, "Yeah that's true in 529 plans because the time frame is much shorter than IRAs, and you're assuming paltry 21st century average investment returns." You are correct, but that's just the way life is now.

Download the college savings plan demo showing the reality of what most people will do, and what they'll actually get - which is getting 3% long-term in a 529 plan after paying 5.5% front-end loads (e.g., a typical American Funds 529 plan). The DIY plan here also returns a whole 3%, so it's comparing apples-to-apples as best as possible.

As you can see, the bottom-line results (between 529 and DIY) are the same. Yes, this is even after all of the tax breaks from the 529 plan. This proves that when both long-term investing returns and taxes are low enough, the benefits of most all tax-wrappers are mostly useless.

Then consider when you invest your college funds yourself, you can most always do much better than what you're stuck with in most all 529 plans (just by having a monkey throw darts are several Vanguard index funds).

So with the investment returns of our new reality, the amount of withdrawal taxes paid is a mere pittance compared to what traditional wisdom has led you to believe. Also, the taxation of dividends and realized capital gains distributions along the way in a non-qualified account is also an even smaller mere pittance - much much less than advertised. This is partly due to near-zero interest rates and yields on just about everything, and then the drastically reduced capital gains distributions in mutual funds (profits).

So the bottom line after finally doing the match correctly, is that the tax advantages of just about every kind of qualified tax wrapper is about one quarter of what you, and everyone else, have postulated since the beginning of time. They're just using 20th century logic combined with 21st century tax rates and investment returns. Capitulate - none of that works like it did anymore.

Things just change, and you should still invest; but these days doing it all yourself without the qualified tax wrapper in a self-directed discount brokerage account makes a lot more sense than it once did. Back in the Stone Age, it wasn't practical or pragmatic. Nowadays, all of those mundane problems have been solved for the individual investor investing their own money.

Between the four investment strategy comparison demos below (created using the investment software here), you'll have the only undisputable proof anywhere that the value of all "tax-wrappers" (all forms of annuities, VUL whole life insurance, 529 college saving plans, and even traditional and Roth IRAs), are mostly to completely useless, unless you can average over 11% annually (which you won't) with the current low tax rates. See the text boxes on the first sheet:

Download the Investment Comparison Demo

Demo Showing Buy Term Life and Invest the Difference (AKA BTID)

Just being able to tap your assets whenever you need to without the huge tax penalties makes up for the greatly reduced tax advantages. Investing in 529 plans, IRAs, and all forms of whole life insurance and/or annuities are the direct opposite of liquid. So just don't do that anymore, it's as simple as that.

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Financial Planning Software that's Fully-Integrated
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Bond Calculators for Duration, Convexity, YTM, Accretion, and Amortization

Investment Software for Comparing the 27 Most Popular Methods of Investing

Rental Real Estate Investing Software

Net Worth Calculator (Balance Sheet Maker) and 75-year Net Worth Projector

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Financial Seminar Covering Retirement Planning and Investment Management

Sales Tools for Financial Adviser Marketing

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TVM Financial Tools and Financial Calculators

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Miscellaneous Pages of Interest
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Primer Tutorial to Learn the Basics of Financial Planning Software

About the Department of Labor's New Fiduciary Rules

Using Asset Allocation to Manage Money

Download Brokerage Data into Spreadsheets

How to Integrate Financial Planning Software Modules to Share Data

CRM and Portfolio Management Software

About Monte Carlo Simulators

About Efficient Frontier Portfolio Optimizers

Calculating Your Investment Risk Tolerance

About Discount Brokers for DIY Money Management

About 401(k) Plan Management

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