Where's The Tax Savings?

Did you ever wonder if there is actually tax savings when you contribute to an IRA, 401k or another pretax investment?  Your CPA or tax consultant will say you are getting money back if you contribute.  The tax deferral is in the plan and not in your pocket!   The cash flow or net income is what you must consider not the supposed tax deduction.

The example above shows you contributing $10,000 pretax which means you will pay less tax but you still had to put the money into the plan which which does not help you with ultimately paying less tax.  The contribution will just give you a delay of tax hoping to be in a lower tax bracket when you retire which would mean you would be receiving less income in retirement.  Lowering your income in retirement would be difficult especially when most of your income that you receive is taxable.  If you are receiving lower income in retirement it would mean you are enjoying less!  Will you lower your standard of living because you retired or will you be spending more money because you are not working 9-5 any more!

I ask these questions!

Do you believe tax brackets will be lower or higher in the future? 

Do you believe you have more or less tax breaks?  

Do you believe you need more income because of inflation?

Do you believe the government will not hijack these tax deferred accounts because they need money?

Do you believe that the tax you where suppose to pay earned more interest because it compounded?

Do you believe that you are deferring tax to just pay more tax in the future?

Miracle of compound interest vs Reality

Reality of Compound Interest 

Building wealth has numerous eroding factors that are not being recognized today by most financial advisers.  Most investors only see their gross return because that is what the financial institutions want you to see.  Investors are using the miracle of compounding interest without understanding the miracle of compounding tax.  The problem is not only the compounding tax it also has a partner called lost opportunity cost!

  

The Ideal World:

The client invested $10,000 into an account earning 8% which would grow in 30 years to $100,627.  End of story!

The Real World:

If the client was in a 25% tax bracket they would pay $22,657 in taxes out of pocket or some other account.  The problem is that tax money could also be earning interest so that lost an additional $23,127 which could earn 6%= (8% x 25%).  This is called lost opportunity cost!  The biggest mistake most financial planning companies are failing to show is what it cost to grow your money.  The real question is why would they show you this?  The reality only hurts performance so performance is  marketed by financial institutions without full disclosure to improve rate of return.

The Real Math:

You have $100,627 in your account but it cost you the initial investment: $10,000, taxes $22,657 and lost opportunity of $23,127. The net result is really costs of $55,784.

The analogy: 

Imagine being in a boat sitting on a still lake and it takes you one hour to cross at 8 knots (8%).  The lake is still with no current and no wind  (Ideal World).  The problem would arise if wind and current starts it might take you two hours to get across the lake even though you are still going the same speed.  The drag  (wind and current) is the problem similar to taxes and lost opportunity cost!  You would need to increase your speed (risk) to get across the lake in the same 1 hour period (retirement).  

Conclusion:

Removing the cost or erosion associated with building wealth is the first step to financial mastery! 

P.S. then add inflation....