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to the plan, the investments grow tax-deferred while in the plan, and are taxed at ordinary income rates when withdrawn fromt he plan.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 vehicles.
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 when you retire you'll probably want to have more income available than when you were working because you have places to go and things to see.
Let me tell you a story about a client of mine. For many years he was a very successful businessman. He set up a very nice pension plan to which he contributed faithfully every year. Then he retired. He paid very few taxes and was actually in a very low tax bracket while he was in business. He no longer had all of these deductions when he retired. 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 the tax.
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 people.