It’s not what you earn, it’s what you keep that matters!
The month of April boasts Fool’s Day and Tax Freedom Day. Coincidence? You decide. Tax Freedom Day answers the question: How many days per year do you work to pay for your government? On average, income taxes consume about 32.7 percent of our income. If we convert that percentage into the average days an American works, and assuming you start the year on January 1, it takes until April 30 for Americans to pay their income taxes. Therefore, May 1 is when you could begin “paying” yourself. For some historical perspective, in 1910 Tax Freedom Day was January 20*. If you are fortunate enough to have a higher income, as many readers of this publication are, you must work longer into the year to pay your disproportionate share of the tax burden; thus your Tax Freedom Day falls in May—the fifth month of the year!
As Tax Freedom Day relates to your retirement and investments, Tax Freedom Day speaks to the current tax year—in effect, the front nine of your investment plan. Have you ever been ahead in the front nine only to “blow up” on the back nine? Has your team ever had a tremendous lead at the end of the third quarter only to lose the game by the end of the fourth? The score that matters most is the one that reflects the winner at the end of the game, or in the case of your financial plan, at retirement. Therefore, it is important to consider the fact that taxes should be a major consideration in your planning because taxation is a significant factor affecting your retirement income security.
Today, Americans have trillions of dollars invested in employer-sponsored retirement accounts (401(k), SEP, SIMPLE, 403B) with a huge “lien”—a potential tax liability where Uncle Sam will impose his will by dictating the amount of the lien—on those assets. Unfortunately, many investors have not properly planned to position themselves to protect the assets they’ve spent a lifetime building. They have no exit strategy for one of their largest assets, their retirement accounts.
Stephen Covey1 succinctly stated, “Begin with the end in mind.” And yet, when it comes to optimizing the value of our investments, we often look at the tax deduction for the current tax year —the front nine—versus the potential impact of today’s tax deduction on our retirement income. By utilizing the current year tax deduction you may be signing up for a future tax burden, and therefore may be creating a liability when you least want or need it, when you begin withdrawing money from your retirement accounts. As you accumulate wealth, doesn’t it make sense to have a brilliant exit strategy in place?
For specific research and strategies I often turn to Ed Slott, one of the most well-known and highly respected CPAs in the country. He is regularly quoted in the The Wall Street Journal, Medical Economics, The New York Times, Physician’s Financial News and Forbes and is also a frequent contributor to The CPA Journal and Trusts & Estates magazine. In his book The Retirement Savings Time Bomb and How to Defuse It, Ed has said, “… you’ve had it drummed into your head that tax-deferral is the name of the retirement game, haven’t you? Well, I have to face the fact that my profession is largely to blame for such arbitrary thinking … Doing nothing … is the surest way to build up your retirement savings account for Uncle Sam.”
The brilliant cyclist Lance Armstrong understood the concept of clearly knowing where the finish line lay. From 1999 through 2005 Armstrong raced 147 stages in the seven Tour de France races that he won. Interestingly, Armstrong won only 15 percent of the stages. Yet, winning only 15 percent of the races propelled him to the best record in history. He clearly understood that being first to the finish line at every stage was not the path to victory; rather he had to strategically plan to win the tour in whole. As it relates to your retirement, one must plan for the end game versus “winning” the short-term race (the annual tax deduction of contributing to a pre-tax retirement account).
As you work toward your own Declaration of Financial Independence, consider where your finish line is. Do you have a brilliant exit strategy for your retirement dollars? Do you have a strategy to get you through the back nine or to keep you ahead all the way through the end of the fourth quarter? Do you have a plan that focuses not only on what you earn, but on what you keep?
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Doug Adler is a senior vice president and registered principal with Raymond James & Associates in East Lansing where he specializes in retirement distributions and investment management.
1Dr. Stephen R. Covey of Provo, Utah is the author of the book “The 7 Habits of Highly Effective People”, and it has sold over 12 million copies in 32 languages in 70 countries. Information on Tax Freedom Day is from Tax Foundation Special Report: America Celebrates Tax Freedom Day, March 28, 2007 (Special Report 152). *Source: Office of Management and Budget; Internal Revenue Service; Congressional Research Service; National Bureau of Economic Research, Tax Foundation.