Transcript: Segment 3
Paul Winkler: Well, Jonathan 401(k) plans are no longer making sense for savers, according to this. This is an opinion piece in Bloomberg. Well, let’s talk a little bit about this article because what’s funny about this article is, I found it earlier in the week, and you just came in and said, “Hey, check out this, Paul!” I was like “This one?” I held it up. We both had the same article. So apparently it must be a good one to talk about.
401(k)s and Pensions
Jonathan Walker: It’d be something that maybe the listeners might find interesting. I mean, the thing to me was just, I don’t know about you, but I’m always, I hesitate to use the word questioning, but, looking at things that are always, in time, as far as what makes the most sense for clients, especially given what we’re doing now, and it’s always a good idea to reevaluate how we’re advising. And this article just kind of struck me as interesting. As far as, the 401(k) plan obviously came around in the early eighties and does it still apply today essentially, with the lower tax rates and some of the other things? Does it still make sense today? And the author of this article basically took the position that it really didn’t.
Paul: Yeah. And the genesis of the 401(k) was back in the period of time when we were starting to get a lot more global competition. Pension companies would have pension plans, and the pension was literally them setting some money so that you work for them. They set aside some money. It’s the ultimate income smoothing, which is a concept. Remember that from—that’s a retirement income certified professional designation that both Johnathan and I hold. And it looks something like this. It had a line going from left to right. And then that one line is perfectly straight all the way across. And that was the need for income, or that was your, that was your spending in essence. And then above that line was another line at the very left most side, you had another line, if you could imagine it was above that line.
And then it, what happened is it dropped down at about the middle closer to the end. It dropped down. And then the rest of the line continued below the initial line. And what it was basically showing was that your income from work was much higher, should be much higher than your expenditures in your early years when you’re first working, getting your first job, you’re raising kids, you’re putting them through college, and you’re doing all of that. And then what would happen is that your income would drop, the idea being that you were going to live off of savings at that particular point. So that was the idea behind the income smoothing. Well, that’s exactly what’s happening is companies pay you and then part of what they would be paying you typically, they would actually put away for your retirement.
And then when you get to retirement, then they pay that out and that makes your life nice and smooth and nice and predictable. Well, the problem is, is, I was talking about in the previous segment, unpredictable circumstances are the rule of life now. And it’s the rule of, it’s always been the rule of life. You think about pension plans that—even when we had pension plans—there were pension plans that were going broke, and then they ran into financial problems. So there’s no such thing as predictability when it really gets down to it. So the idea behind the 401(k) plan was this, “Hey, we’ll pay you a decent wage, but you’re going to take care of your own retirement.” Because now we’re dealing with multinational competition. We’re not the only game in town making cars anymore in the United States of America. There is Japan; there is Korea.
There is you name it. There are a lot of different countries, Germany, France, and you’ve got a lot of competition and they don’t necessarily have the same level of expenditures that we do. And their labor costs might be lower, and because their labor costs might be lower, we’ve got to find ways to save money. And one obvious place to do that is through pension plans. And the reason being is that for better or worse, people didn’t necessarily appreciate the pension as much. Why? Because what do we tend to be as humans? Currently focused. What’s going on right now? Will you show me the money?
But show me the money right now. So we don’t necessarily appreciate the future benefits as much. So that was one of the things that companies could do away with. So the 401(k) basically says, “Hey, we’re gonna let you not take income right now. We call it deferred compensation. We’ll let you defer some of your compensation for the future. Now, when they came out with this plan, the top tax bracket was 43%, they said in this article. And I thought it was 63% back then. I’m not so sure about that. May have been more of a marginal fit federal for the average person might have been at that level. Cause I remember it being higher than that. Yeah. Cause I remember Reagan dropping it down to two tax brackets, 28% and 15% when he came into office.
He promised he was going to drop that. And the reality of it was this: Hardly anybody was paying that really high tax bracket. You’ll hear people say, well, at one point in time, the marginal tax rate in America was 91% and yeah, but nobody was paying it. Yeah. The reality of it was, it was just smoke and mirrors because you had all kinds of deductions and two for one and three for one deductions and different things that you could do to totally avoid it.
Jonathan: Yeah. I just looked it up. Yeah, you’re right. The marginal rates, what he states in this article, but the actual tax rates were higher at the time. So the margin on what was the actual marginal top marginal rate is 64%.
Paul: Okay. Alright. That was 63% was in my head. That was close. So what are your impressions of this Jonathan?
Income Tax and Retirement
Jonathan: I think it is interesting. From a planning standpoint, I do really think you have to look and, and to me, I think the article does a good job of generating the conversation. I think from there, you have to take it and actually apply it where it would come into a planning.
Paul: And I think that’s where it breaks down, quite frankly. And that article breaks down in a big way.
I do too. I find that for me, when you look at tax rates, the article makes the assumption that income and retirement is all gonna be W2 income or something of that nature. So we’ve got different sourcing of income in retirement. Whereas during my working years, all of my income is W2, or it could be 1099 if I’m self-employed or something of that nature.
So my sourcing of income in retirement could be completely different. I can have the same, on some level, the same amount of income, but my tax structure on that income could be completely different. So I think it’s really going to be a, not a broad brush stroke, like in this article, but I think it’s going to really be looking at what factors are producing that income and whether it makes sense to go to the left of the right at the fork in the road and in a client’s particular situation. Realize that the issue to me is this, that there has always been, and will most likely continue to be, a level of income that you can earn, which there are no taxes on.
Jonathan: Not only that you’re controlling your income in retirement, right? I mean, let’s use my parents for example. So my dad for all intents and purposes probably fell into the quote unquote median income—married couple with two children like in this article. But when he retired, now he has the luxury of controlling whether he works, whether he takes an income from a retirement account, whether he files for social security, what he does to produce that income. And just that alone is just naturally going to reduce his taxes.
So he could have the opportunity to pull money out of a retirement account at a lower tax bracket, right at that time, regardless of what the tax structure is. So those are some things that you have to really kind of look at when you’re planning that retirement income, where this article doesn’t take that into consideration.
Paul: Well, he has significantly fallen out of favor on the Republican side of the ticket, but Mr. Mitt Romney made a point when he was running for president, that there were about half of the population really didn’t care a whole lot about much of anything regarding income taxes because of the fact that they weren’t paying income taxes. And the reality of it is, if you look around the world there has, and here in the United States, certainly, and always has been the case, a level of income. You can’t go and take the person that is earning a low income and say, Hey, I’m going to take your low income and I’m going to make mincemeat out of it by taxing it even further.
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So the reality of it is there is a push to make sure that there’s a living wage and that that doesn’t get subjected to high income tax rates. Now it does get subjected to social security taxes. But reality is you’re going to get that back in the future, because if you take a person’s income throughout their life, and that’s the way social security works, take your income and all the income you’ve earned, take your top 35 years, bring it to today’s dollars when you hit retirement age, and then you look at that average income and they will replace the first 10,000 of income at a rate of about 90%. It is 90% of approximately $10,000. And then your next $50,000 of income. So let’s say that your average income, just so that I’m not talking in Greek to you, no offense to Greeks. If you’ve got $40,000 of income, your first 10 of that income is going to be replaced at 90%.
The next $30,000 of income is replaced at 32%. Now, if you go above the 50, so it’s above $60,000 in my example, 10 plus the 50, then that’s going to be replaced at 15%. So in effect, social security, most of your low income people—and that’s what I’m talking about—the skewing toward the lower income people are getting the vast majority of their income replaced by social security. So it’s completely fair for them to be paying taxes on that income, but income taxes, you could say it’s absolutely fair, and you wouldn’t get any argument out of me, but from a social economic standpoint, it just doesn’t happen. We’ve never had it happen. And the reason is because a lot of those people vote, and I like what—I think it was Abraham Lincoln, he said, you know what, God must have really liked the common person cause he made so many of them.
And, and the reality of it is they vote, and anybody coming in saying, “Hey, we’re going to raise taxes on people making less than $20,000.” It’s probably not going to fly. And right now you have about $25,000 of income that you can earn and there is no taxes on it whatsoever. Above that you get to a 10% rate, which is still minuscule. It’s still minuscule.
Now, as he says in the article, there are a lot of people in marginal tax rate, 43. It’s 12% today. Well, he’s not talking about the top rate. I just noticed that. So absolutely not the top rate. So that’s why I got thrown. So he’s just talking about what the average person was at in 1980.
I average person at 12%, because you can earn your first $25,000, 0% tax rate and married filing jointly in the next 20,000, approximately—and I’m rounding—is taxed at 10%. The next $55,000 is taxed at 12%. So the vast majority, that gets most people, $25,000 plus $20,000 plus $55,000, you’re up at about a hundred thousand dollars. Reality of it is, the average family in America is at like $60,000. So most people are in a 12%. So if I put money in pretax in a 401(k) plan, that’s what I’m avoiding. I’m avoiding that particular tax rate. Now the question is, what is the tax rate, when I pull it out at later on? And this particular person’s point of view is it’s probably not going to be less than 12% in the future. And let’s talk after this break.
Let’s talk a little bit about why that’s kind of a misleading argument and why it really misses the boat. Well, because people that I’ve seen a writers, columnists scare people with this kind of stuff, Oh, the 401(k)s going away, or they’re going to tax it all. They’re going to steal your 401(k) and all that. That’s not what this is, in this particular case. That argument was floated about 12 years ago, and the lady that floated it had to hire body guards. So that’s not what this is talking about, but how do you approach 401(k)s and Jonathan, I want you to talk a little bit about what are some alternate ways, because there are partial truths in anything that we read. What do we do with this kind of information?
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