Since the time we could spell “401k” and “IRA”, we’ve all been told that we should always, without question, contribute the maximum amount. While I will not use this blog to discuss whether that advice is good or bad for the average or higher-income American, which is questionable, I can say that (by my estimation) this is bad advice for successful entrepreneurs 90% of the time.
Many times, I ask why someone is contributing to a qualified retirement account (like an IRA, 401k, SEP, SIMPLE), and the answers all come back the same: it’s easy, there’s a match, it’s pre-tax, and for the tax advantages. As to the “tax advantages” answer, I always ask them to please explain for me the exact set of tax circumstances that must exist in order for them to receive those tax benefits. Occasionally, somebody actually gets it right, but most of the answers are “I don’t know.” (Interestingly enough, there are a higher number of people than you would think who do not know that the income from a retirement account is even taxable, much less at ordinary income tax rates.)
Answer: the exact tax situation that you must encounter to benefit from the “tax savings” of a 401k is that you must pay less in taxes when you pull the money out of the retirement account than the tax deferral you received when you put it in.
I have a number of clients who are actually paying more in taxes now than the tax deferral they got when they were making the contributions! Again, in speaking about the successful entrepreneur, although they all want to minimize the taxes that they pay, they never really desire to be in a lower tax bracket. As I tell them, if you are in a lower tax bracket at age 65 or 70, it will not have been my fault!
In addition, regarding these retirement plans, there is no ability to manipulate your tax situation with money withdrawn from a retirement account. At 70½ years old, each person must take out what is called a Required Minimum Distributions (RMD) which the government calculates. If you do not take the RMD, the government levies a 50% tax! In addition, these assets are always included in your estate and even upon death, the account is subject to ordinary income taxes (called Income in Respect of a Decedent (IRD)).
Now I do not have a crystal ball and cannot predict the future, much less how taxes will go, but I have seen the *top 1% of income earners’ share of the U.S. tax burden climb steadily over the years. I have a question that everyone should ask themselves: Do you think over the next 20-30 years taxes are going up, down, or will stay the same? Additionally, what about for the top 1% of income earners? Do you think their taxes are going up, down, or staying the same?
Many times, however, to make a good decision about contributing to a retirement account or not, you don’t have to accurately predict taxes in the future, because over the years I have come to find that the #1, most important financial concern to entrepreneurs is access and control of capital.
For me, the biggest reason to not fund a retirement account is to maintain access and control of the money in order to be able to invest in entrepreneurial assets such as closely held businesses and real-estate. Over the years, I have seen clients unable to access their retirement accounts, so they could not take advantage of great entrepreneurial opportunities. They simply chose not to make the investment because of the taxes and penalties they would have to pay.
In summary, funding retirement accounts, in spite of everything you have been told, isn’t always the wisest choice for those great savers in the higher tax brackets or for successful entrepreneurs.
Up next, we’ll dive into #7 of the 10 Most Common Business Owner Blind Spots series – Personal Life Insurance. Stay tuned!