Debt-Free Retirement: the one mistake creating more debt

By: Don Meyer

Most people agree that debt is bad. People want to get out of credit card debt and pay off student loans and their mortgage. Those are all great goals to get you out of debt.

But if you follow the advice of anyone who suggests that you exclusively save in your 401(k) or IRA, you may be creating more debt. But debt to whom? Debt is defined as money that is owed or due. If you save for retirement in these types of qualified plans, you are creating a future debt to the IRS when you need your money the most.

Think about it: When you save in these qualified plans, you are getting a tax break now by not having to pay taxes on the amount you contribute.

Then, when you retire and need to withdraw the money, you pay the taxes. The conventional wisdom is that you’ll be in a lower tax bracket when you retire. But do you really think taxes are going to be lower in the future?

Most people just want to have as much money as they can now — and of course, no one wants to pay more in taxes, so deferring those taxes sounds like a good idea. But here is what this actually meant for one of my clients.

He was 39 years old when we met and planned on retiring at 65 as many people do. Work was going well so he was saving a lot of money and would plan to continue up to retirement. We assumed a 5.5% return between now and retirement and a 4.75% return during retirement with a 1.5% account fee in all years. So that means by saving in a 401(k) he would defer, or save, $185,760 from that day until retirement. Not bad, right?

However, in retirement, he would expect to pay at least $397,475 back in taxes. That’s assuming he is in a lower tax bracket when he retires but since he wants to maintain the same standard of living in retirement that will not be likely. So, his taxes could be much higher.

So, if he kept saving in his 401(k), his debt (the amount he would pay in taxes) in retirement would be nearly $400,000 at least. His income from that one asset would be $41,000 after taxes. 

I have shown hundreds of people what their tax bill, or debt to the IRS, will be in retirement, and no one is very excited about deferring taxes at that point.

The bad news is if you have been saving in a qualified plan, then you owe the IRS its share of your money. That is what you signed up for, even if you didn’t realize it at the time. So, you owe the IRS some money. The good news is that there are a couple of alternate options. You can convert or save in a Roth account, or you can use Section 7702 of Title 26 of the IRS tax code.

Switching to a Section 7702 plan could save the 39-year-old I mentioned above over $200,000 in taxes because he is paying taxes on the money now, at known rates. His income in retirement will be over $90,000 a year, all tax-free.

Section 7702 plans may be right for people who:

• Are maxing out their current savings program.

• Are contributing over the employer match.

• Are concerned about taxes increasing in the future.

• Are high-income earners looking to make up for lost time.

• Are looking for risk and tax immunization for a portion of their retirement assets.

This tax code lets you draw your income out tax-free. To make it even more appealing, it has zero market risk. You may be thinking that if it has zero market risk then it has zero return potential, but that’s not true. You can earn as much as the market grows in many situations.

According to my calculations, from 2000 to 2019, the S&P saw an average return of 6.09% before taxes and fees came out. So that number is closer to 4% or 4.5%. In the illustrations prepared, the 7702 plans saw an average return of 6.29%, net of fee and tax-free.

The 7702 plans are not for everyone. You must qualify for them based on your financial situation, age, and health. If you don’t qualify for a 7702 plan, you may still want to consider using a Roth IRA either for your annual savings or for converting some of your current qualified plans to a Roth so you pay the taxes now at a known rate, instead of in the future at unknown rates that may be higher.

Don’t get me wrong: Qualified plans are not bad. They just don’t need to be your only retirement plan. If being debt-free is one of your financial goals, then you need to reconsider your retirement savings strategy.

Contact me or your agent if you want to know how to get out of debt in retirement and increase your income substantially. 

ABOUT THE AUTHOR: Don is the President and Co-Founder of Both Hands FG.