Qualified Plans: How to Explain What They Do to Clients

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Advisors know there is nothing wrong with putting money in qualified plans. In fact, they are great long-term savings accounts that provide tax deferral on the growth of the dollars contributed. They are not tax savings plans; they are tax deferred savings plans, which is a big difference.

The fact that these plans are widely misunderstood is the place where you will want to focus your attention with your clients. As discussed in the Circle of Wealth® system, we are reminded of tic-tac-toe and the story of the rules of the game. It is important to learn and develop strategies in order to be successful.

You may not remember your first time playing tic-tac-toe, but you can likely guess who won; it was probably the person who showed you the game. Tic-tac-toe has a few simple rules. They likely told you that the object was to get three in a row. They’d choose X and you were O. We played this game as kids and lost continuously until we learned the strategy of the game.

Many people are playing this ‘financial game’ so to speak with little to no understanding of how the game is played.

How to Explain Qualified Plans

When communicating about this subject, remember qualified plans do two things:

1) They defer the tax, AND
2) They defer the tax calculation.

The part that clients are interested in is the deferred taxes. The part the IRS is interested in is the deferred tax calculation.

The IRS is not going to ask you what tax bracket you were in the day you made the contribution. Their only concern is going to be what tax bracket are you in at the time of withdrawal.

What Do Qualified Plans Do?

Clients are often misinformed about the account which often holds their largest retirement savings dollars. When asked, “What do qualified plans do?” they respond with the fact that “they defer taxes” (which is true), and some are of the belief that they are “saving taxes” (which is possible but not necessarily true), depending on future tax brackets. They also defer the tax calculation.

Perhaps a better term to use would be “postpone” taxes. The government is not saying you do not have to pay tax on these dollars; what it is saying is you can pay it later. At what bracket? Now that is a good question. Since the taxes are “postponed,” it is misleading to use the phrase “tax savings” in conjunction with Qualified Plans.

Since the calculation of taxes is deferred until withdrawn, Qualified Plan contributions could be a good choice if you retire in a lower tax bracket than you were in at the time of your contributions. A company match will also have a positive impact on future tax liability.

However, if you believe you could retire in a higher tax bracket, then perhaps you need to take a closer look at other options. Since no one knows what taxes will be in the future, looking at the past can provide insight into where you think they may go moving forward. In addition to the tax history, you need to also understand the impact “Tax Thresholds” will play on your future qualified plan withdrawals.

The Check Story (An Example of What QPs Really Do)

12122703 - closeup of a businesswoman doing finances in the officeBelow is a story you can share with your clients to help you explain what qualified plans really do.

“You call me one day and want to borrow $10,000. I hand you the check, but before you take it you are going to ask me two questions. The first is how much interest am I going to charge you and the second is when do you have to pay it back?

Suppose I said to you I am doing fine right now and do not need the money, but there will come a day when I need it and when I know how much I need we can figure out how much interest I need to charge you to get how much I need.

Would you cash that check? No, but you are standing in line in your Qualified Plan to do exactly that with the federal government.

They did not say you don’t owe the money; they said they will let you know the cost later.”

Qualified plans provide a great advantage: tax-deferred growth. As we’ve discussed previously, compound interest in a taxable account is less favorable because of the opportunity cost lost on paying taxes that could be deferred or avoided.

Loss of control is something else your prospect should understand before putting all their eggs in this basket. Carrying non-deductible debt while making contributions to qualified accounts can nullify any future gain these accounts are used to generate. Make sure your clients are not losing more along the way than they will have accumulated in their qualified retirement account.

The Return Potential of Qualified Plans

Increasing the withdrawal tax bracket will decrease the internal rate of return, and decreasing the withdrawal tax bracket will increase the return.

Here is how you can explain the return potential to your client:

“Let us use rate of return first. Let us assume a $2,000 annual contribution with no match and an investment return of 8%. If we look at three working periods of your life (in this case each period is for ten years) and keep the tax bracket at 30% for all three periods as well, at the time of withdrawal we will see that the investment’s overall internal rate of return is 8%. This proves the calculator is correct. If we change the withdrawal rate up we will notice that our rate of return will go down. If we change the withdrawal rate down we will notice that our rate of return will go up. The tax rate at the time of withdrawal has a dramatic impact on what happens to the money from a qualified plan.”

Are the Savings Real or Apparent?

With qualified plans, you do not save taxes – you defer them. When you defer the taxes you also defer the future tax calculation. The taxes you defer are really apparent tax savings, but you will not be sure until withdrawal.

Here’s how to explain the deferred taxes to your clients:

10694923 - couple in meeting with a financial planner“If we begin with a $2,000 annual contribution and a 30% tax bracket, both currently and at withdrawal over a 30-year period with a return of 8% we will notice the following. Our account balance will be $244,692, of which we receive $171,284 and the government gets $73,408. The apparent taxes deferred are $18,000. The IRS wants the $600 of apparent tax savings we received during the years of contribution back at interest. Since we earned 8% on our money, the IRS wants their money back at 8% as well and the total comes to $73,408. Should the withdrawal tax bracket increase or decrease, our apparent taxes deferred will not change because we are assuming a constant tax bracket during the years of contribution. If the withdrawal tax bracket increases, the government will receive a bigger piece of the pie. However, the apparent tax benefit we thought we received did not change. If the withdrawal tax bracket is lower, than we actually received more tax benefits than we anticipated compared to our bracket at the time of contribution. Remember the key is that not only are you deferring the taxes, but you are also deferring the tax calculation.”

What Your Clients Need to Consider

After you’ve gone through the above points and conversation examples, emphasize these three points qualified plan owners should consider:

  1. What tax bracket will you be in by retirement?
  2. What deductions will you have when you take the money?
  3. What is your exit strategy?

Are you ready to discuss qualified plans with your clients?

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