For decades, our federal government has allowed us to save for the future using tax deferred accounts like 401(k)s, 403(b)s and IRAs. In many circumstances, our contributions to these accounts are made with pretax dollars thus enabling us to save more today. This can often be a great savings strategy if indeed an individual’s tax rate in the future (when the money is withdrawn) is lower than the individual’s tax rate today. However, one is wise to remember that Uncle Sam will eventually take his share.
As these accounts are invested, no tax is due on the growth. When cash is later withdrawn, income tax is then generally payable at the individual’s tax rate at the time of withdrawal. Many will find it interesting that, as the account grows in value, only part of the growth belongs to the individual. Uncle Sam will also be standing there demanding his “fair” share of that growth.
Allow me to illustrate with the following example.*
- Joe saves $10,000 to his 401(k) account. His tax rate is 25%.
- Technically, he has contributed $7,500 to the 401(k) while Uncle Sam contributed the other $2,500. (If Joe hadn’t saved to his 401(k), the $10,000 would be fully taxable meaning he would have only $7,500 net of tax.)
- Over the next 12 months, Joe’s account grows by 10% and is now worth $11,000. (For simplicity, we’ll assume he’s unable to make contributions over that 12 month period.)
- If Joe were now retired and in need of the entire $11,000 for spending, he would have to pay $2,750 in income tax assuming his tax rate is still 25%. That would give him $8,250 of cash to spend ($11,000 – $2,750). Therefore, of the $1,000 in growth over those 12 months, Joe only gets to keep $750 (75%) while the other $250 (25%) of the growth belongs to Uncle Sam.
- In other words, Joe received a 10% return on his initial $7,500 while Uncle Sam received a 10% return on “his” initial $2,500. In this instance, Uncle Sam still has his hand deep in Joe’s wallet – actually, in his 401(k) account.
For financially successful and responsible individuals who have accumulated large balances in these types of tax deferred accounts, you’re wise to remember that neither the entire balance nor all of the account growth likely belongs to you. Uncle Sam is waiting to take his “fair” share. His share will, of course, depend on future tax rates and your specific situation. A professional team can often prove invaluable in strategically and legally limiting Uncle Sam’s share.
How deep is Uncle Sam’s hand in your wallet? Remember, he’s not really your uncle!
*Tax code is typically more complex than this, but we’ve used a simplified example here to illustrate our point.
Published: July 31, 2015
Authored by: Terry Prather, CFP®, ChFC®
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