Chapter Ten e Great Bait and Switch

Chapter Ten

e Great Bait and Switch

It’s no secret that the government wants its taxes from us. And with a 401(k), they have built in a way to make sure we give it to them.

What isn’t so clear, though, is the way they trick us into giving them even more of our money than we realize in the form of taxes. We are lured into putting money into a 401(k) plan because of the tax breaks we get. e contributions go in before tax, and then our money grows tax deferred until we pull it out. at’s the bait.

But what most people don’t realize is that the way the government has set up the rules, it is actually a huge tax DISADVANTAGE when we pull that money out. In fact, we’re going to see how putting money into a 401(k) account is perhaps the worst possible place to put your retirement investments from a tax perspective.

You Don’t Own Your House or Your 401(k)

For many people the two places they have channeled most of their money is in their house and in their retirement plan. But do these things really belong to you or do they belong to the government?

From a certain perspective we never really own our home as long as we must pay property taxes. In a sense, we might say we “rent” our homes from the government. If we don’t pay the rent, the government places a lien on your home. So even if you have paid the mortgage on your home in full, property taxes still pick your pocket.

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In a certain light the government also owns the money in your 401(k) and allows the nancial industry to skim it until they see t to return ownership to you. While government and the Wall Street elite have been bedfellows for decades, the cartel they have formed today is truly profound. As we discovered in the last two chapters, the nancial institutions can make maximum pro t on your money when: a) ey take hold of your money, and b) keep it for as long as possible.

It’s not surprising that the laws surrounding the 401(k) are going to try to ensure both of those things. First, get the money with the bait of a tax bene t, and then keep the money with the punishment of a tax penalty for early distribution.

Once they have your cash, it is no longer yours. ey won’t return ownership until their buddies on Wall Street get a decade or two worth of fees.

If you still think the money in your 401(k) is yours, then try to get it back. e only way to get it back before the allotted time is to buy it back. ey own it, not you. ey control that money, not you. And the penalty rate you pay to buy your money back is a full 10%. e reality is that you are forced to spend $100 to buy $90. us, early distribution becomes unattractive. Your own money seems to become virtually untouchable.

Understanding taxes is not a suggestion but a requirement for the investor. Yet it is largely out of sight and out of mind for the employee. Taxes are an employee’s greatest liability by far. Taxes take more money away from the average person than anything else, including our homes.

Consider all of the taxes you pay during the course of a year: Income tax Social Security tax Unemployment tax Property tax Sales tax

Estate tax Capital gains tax Luxury tax Gas tax Hotel tax Food tax

Beer tax

Cigarette tax Toll bridges State registrations Various government fees

For many of us, income tax is the largest tax bill we pay. And it’s important to understand that, depending on someone’s income level, they will be taxed at a di erent rate.

Ordinary Income

If a person goes to work in the United States and they receive a salary or wage, that income they earn is called “ordinary income.” Depending on a person’s individual situation they can be required to pay up to 35% of everything they make to the government. is number changes periodically as di erent groups of politicians get in o ce. Considering government’s addiction to our tax money, it’s easy to assume that this percentage rate will continue to climb in the coming years.

Capital Gains

Di erent from ordinary income, capital gains refers to the pro ts made by buying and selling something. is can be things such as real estate, gold,

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silver, stocks, or mutual funds. In the United States, the going tax rate for capital gains is currently 15%.

What this means is that a person can pay more than double the amount of tax on money earned as a worker versus money earned as an investor. at’s just one of the reasons investors are so keen on investing. e tax burden is much less than that on the money you “work” for.

e Bait and Switch

Looking again at our example in the last chapter, our investor was le with $30,000 in her 401(k) account a er giving $110,000 to the nancial system managing her money. One of the reasons that an investor would put $1,000 into their 401(k) account in the rst place is the allure of a tax deferral.

In the United States tax code there are over 5,000 pages of rules and regulations. Only a handful of pages include instructions on how much tax we need to pay. e bulk of the tax code is a set of instructions on how to defer or reduce taxes through deductions and credits. Our 401(k) contributions are categorized as tax deferred, which means that the tax is paid later when we pull that money out during retirement.

Here is what that tax deferral looks like in our illustrated example:

A er we get past the shock of only having $30,000 in our account a er all that time it has been invested, it’s time to draw it out. On paper, we can show that the initial $1,000 invested was ordinary income because it came from our paycheck and our employer’s matching contribution. e remaining $29,000 is pro t from market gains.

In a normal investing situation, that $29,000 would be taxed as a capital gain. But this is where the government pulls a sneaky bait and switch on us. For some reason, they don’t categorize 401(k) plans the same as other investments. Instead of paying the 15% capital gains tax on the $29,000 increase, the entire account total will be taxed as ordinary income.

Paying ordinary income tax on your 401(k) pro ts looks like this:

Here’s how it works: $30,000 × 35% = $10,500 is paid in taxes. e investor is allowed to keep $19,500 of the account.

However, if it were taxed as a capital gains increase your 401(k) pro ts would look like this: ($1,000 × 35%) + ($29,000 × 15%) = $4,700 in taxes. e investor in this scenario would keep $25,300 of their account.

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So in an e ort to defer $350 in tax today, this investor will wind up paying over $5,000 more than needed on the original $1,000 put into that 401(k) account.

Yes, you are understanding this analysis correctly. You can pay up to 20% more in taxes on your 401(k) money than you will on regular investment capital gains.

My good friend Tom Wheelwright is a top tax expert in the world. Tom has a wide variety of professional experience, ranging from Big 4 accounting, where he managed the professional training for thousands of CPAs in the national o ce, to in-house tax advisor for a Fortune 500 company. Tom later founded ProVision, a company that specializes in helping sophisticated investors reduce their tax liability by proper tax planning and implementing wise tax strategies as well as investor education.

Since I am not an accountant or a tax attorney, I thought it very important to include Tom’s perceptive on the tax problem with 401(k)s. I am so grateful to Tom for his willingness to help people discover mustknow information about the tax implications of the 401(k) and IRAs that have become so commonplace.

Tom Wheelwright:

“ e tax consequences of using a 401(k) are actually much worse than Andy is suggesting. Besides shi ing your capital gains from a 15% tax bracket to a higher tax bracket, you are also increasing your overall taxes on your investment income as a result of in ation. Unless you plan on retiring poor, making a lot less money than you did while you were working, in ation will put you into a higher tax bracket when you retire than you would be while you are working. Even without in ation, you will be in a higher tax bracket, simply because you won’t have the deductions for your children, your home and your business when you retire.

“Of course, if our only choice were to pay more taxes later or fewer taxes today, we might still decide to postpone our taxes. It’s a little like eating dinner. I always like to eat vegetables last because I might die before

I have to eat them. e same would be true for taxes if we didn’t have another choice.

“But what if you could permanently reduce your taxes instead of just postponing them? In fact, over 80% of the tax code is dedicated to showing you how to permanently reduce your taxes. My book, Tax-Free Wealth, shows entrepreneurs and investors how to permanently reduce their taxes by 10–40% or more. You can nd out more at www.taxfreewealthbook.com.”

You May Also Be Paying Someone Else’s Taxes

Taxation of mutual funds can be as crazy as their fees. Here’s another shocking example. Shares of stocks in mutual funds are constantly being bought and sold as people leave the fund, enter the fund, or as the fund manager changes up the holdings of the fund. is means that the fund must pay taxes on some of these transactions.

Guess who they pass those taxes on to? at’s right, they pass it on to us as the investors. is is where it gets a little crazy. Depending on when you enter the fund you could actually be paying part of the taxes on these trades even if you have seen a loss since you have been in the fund.

From my research, I think it’s about the only time you are required to pay taxes on something you earned no money from.

Plan to Live the Way You Really Desire

I have always been confused with the way many retirement planners set up strategies for their clients. ey actually recommend that people plan on living a lifestyle which is less than they are living now because they know the actual returns they will get from 401(k)s and mutual funds are so utterly pathetic. Apparently downgrading is acceptable to these planners as a legitimate way of helping their clients. ey literally show clients how to be poorer in the future.

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I am shocked that planners don’t realize that they are truly sentencing their clients to a retirement of poverty. Not only are these investors being pushed into living on far less income than they are accustomed to, they will also be dealing with higher cost of living prices due to in ation and other economic pressures.

For me, this kind of advice is ill-conceived, wrong, and ultimately harmful.

I believe that given the choice, people will instead want retirement plans that can increase their cash ow throughout their lives and into retirement. To do this may require stepping out of the shadow of the current retirement system because it is not helping you reach your goal. e rst step is to begin gaining a nancial education about di erent retirement account possibilities as well as investing strategies and principles to guide your decisions. Learn the language of investing so you can discuss these issues with con dence.

Finally, please don’t ever forget that these contribution accounts are designed to be supplemental. ey are meant to be a portion of your plan, not the entire plan by themselves. Many people also have additional investment accounts, or real estate holdings, or a business to help them generate cash ow for their goals. Whatever you decide to do, be aware of the tax implications of your decisions. Work with a quali ed accountant to help you understand and plan for the tax liability. Proper tax planning can keep you out of trouble and put additional dollars in your pocket.