SEP's, IRA's, 401(k)'s and RRSP's
SEP's, IRA's, 401(k)'s and RRSP's
One of the most common questions I get regards
"tax-favored" investment vehicles such as Self-employed
Retirement Plans (SEP's), IRA's, 401(k)'s, and, in Canada,
RRSP's. With the exception of the Roth IRA and Roth 401(k),
these vehicles primarily rely on the time-honored tradition
that paying taxes later is better than paying taxes today.
In each of these (except Roth's), the taxpayer receives a
deduction today for their contribution to the plan, the
investments grow tax-deferred while in the plan, and are
taxed at ordinary income rates when withdrawn fromt he plan.
Sounds like a great plan, right? Wrong!!! Let me briefly
outline my complaints about these types of investment
1. The tax benefits rely on the premise that when you
retire, you will be in a lower tax bracket than you are
now. Unfortunately, this is true for many people who use
these vehicles, because they will retire poor. However, if
you want to retire rich, you will likely be in a much
higher tax bracket than you are now. Why? You will have
fewer deductions. No business deductions (remember, you are
retired), no dependent exemptions, no home mortgage
interest. And you probably want to have more income
available when you retire than when you are working because
you have places to go and things to see.
Let me tell you a story about a client of mine. He was a
very successful businessman for many years. He set up a
very nice pension plan to which he contributed faithfully
every year. Then he retired. While he was in business, he
paid very few taxes and was actually in a very low tax
bracket. When he retired, though, he no longer had all of
these deductions. Immediately, he was in the highest tax
bracket possible. He complained to me constantly about his
high taxes. But, given that he was retired and all of his
income was coming as distributions from his pension plan,
there was nothing I could do for him. He just had to pay
2. You have very little control over the funds. Who has
control? The government. They control what you can invest
in, how much you can add to your investment and when you
can take it out. I find that this lack of control normally
results in lower returns.
3. You can't take advantage of other tax-advantaged
investments. For example, you cannot receive the tax
advantages (e.g., depreciation) from real estate to produce
lower taxes from your other income. You don't receive
capital gains treatment from dividends and long-term stock
gains. And, if you do invest in a business (a very
complicated matter within a tax-deferred plan), you are
severely restricted as to your operating entity.
There are times when these arrangements can be very
profitable. I know several options traders who use their
self-directed IRA's for option trading. Since there are no
current tax benefits for option trading, why not defer the
tax? The same goes with hard money loans.
My gripe with SEP's, IRA's, 401(k)'s and RRSP's is that the
financial institutions and the government push them so hard
that people think they are the ONLY alternative. There are
many other ways to save taxes that are much better for many
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