Since 1976 we have all been told that the 401K was the best retirement concept since sliced bread. After all, you get to put money away pre-tax, reducing your current taxes, your employer may even match a portion of it and you will be able to withdraw it when you need it, in retirement, at a lower tax rate than before.

Hogwash! Lets look at the numbers. For the sake of argument you put in the maximum amount allowed into your 401K. Today that is $17,500 if you are under fifty years of age and $23,000 if you are over 60 years of age. The amount you set aside is still subject to social security and medicare tax so we won’t even discuss that issue.

If you are 40 years old and you put $17,500 aside you are probably in the 25% tax bracket which means that contribution saves you $4,375 in income taxes in a year. Do that for the next ten years and you have saved $43,750, always assuming that tax rates stay the same for the next ten years and that the benefit is still available for the next ten years. President Obama has already made suggestions along the line of taxing or limiting your benefit if your account balance could finance an annuity paying $205,000 per year. Currently, for a 60 year old, that would be $3.2 million. You say great, I will never have that sort of money. You will if you saved the money judiciously during your entire working career, or if you are a [union] pension holder, which is another category that the President is talking about taking. [See MarketWatch, September 9, 2013]. For simplicity sake, we will ignore the change in tax rate issue and the loss of the benefit if you save too much.

The biggest issues for baby boomers today, however, is not if they die to early but what happens if they out live their retirement savings. The current life expectancy of a woman is 95 years and for a man is 89 years. Do you think this number is going to get bigger or smaller in the next decade or two? My guess, we are going to be living longer. That mean if you retire at the social security retirement age of 67, for most baby boomers. you can expect have to live on your retirement income for 32 to 38 years. Do you have enough put aside?

Let’s look at that 401K again. Lets just say you were a good saver and are going to be penny wise in your retirement. You predict that you are only going to need $5,000 a month to live on. You have to admit that you will not be living lavishly and going to the Caribbean every year and to Europe every other year on $5,000 a month.

How much do you have to withdraw to live on $5,000 each month? Lets face it, when you retire you probably will not have any exemptions on your tax return, you will probably have very few, if any itemized deductions because most of us hope not to have a mortgage payment because we have paid it off either by paying the 30 year mortgage or selling our house and downsizing. That means almost every dollar you withdraw will be subject to income tax, plus the impact on the social security you receive. Just to cover federal taxes, based on the 2012 tax tables, you would have to take out close to $75,000 a year to keep $5,000 per month. That is NOT including any state tax. If you add state taxes to it you could be adding another $9,000 to that number. So to have $5,000 a month in retirement income you would have to withdraw almost $7,000 a month. Are you ready to do that for 35 years?

Remember these numbers only get worse if you want to live on more than $5,000 a month. Our tax schedules are progressive which means the more money you have the more they are going to tax it. Further, f that $43,750 you saved in taxes you will probably only get to keep $31, 750.

This is always assuming we do not have another 2007 to 2009 when the 401K became 101K as you lost as much as 75% of your contributions in the slide in values of your investments. Sure you may be back to the same point as you were in 2007 but you have lost six years of the benefit of compounding of interest.

If you want to do something about this problem you need to be looking at it NOW. Take a look at Internal Revenue Code section 7702(a) and then contact me to see how we can use that to help build REAL TAX FREE retirement accounts.