Ok, ok, that’s just a teaser line. But there is truth to the title, and it affects every employee in the country—not just public safety employees.
Daily, and in every business or municipal jurisdiction, employees are approached by salespersons at fund companies to review the amount they plan to contribute to their supplemental 401k, 403b, or deferred comp pension plans. The conversation goes like this:
My spouse says we can afford to contribute $1,000 per month this plan.
Well, what if we put $1,500 into this plan, you will get a $500 tax deduction so that your paycheck will still only be reduced to the $1,000 per month your spouse discussed?
That sounds good, but my wife told me to ask you about a “Roth” option within the plan?
Ahh, that’s a tax issue. You have to talk to your CPA about that. So, can I get you started on the $1,500 per month today? You can always change it later if you find out differently from your tax advisor.
Ok, I guess so.
Below, I will discuss the conflict the salesperson has and why his evasiveness is costing employees from all sectors, millions of dollars in unnecessary taxes.
The mechanics of a Roth
If the public safety officer above had put $1,000 into a Roth pension plan, he would not have received a tax deduction. Only $1,000 would be invested instead of $1,500. But, when the Roth contributor takes the money out in 20 to 30 years, it will be tax free. On the other hand, had the public safety officer bought into the salesperson’s lines, and had $1,500 growing, they would owe taxes when the money is taken out—and it will probably be at a higher tax bracket.
A non-Roth creates an illusion of wealth
I frequently hear people brag about their supplemental pensions, “I have $1 million in my 401k (or 403b, deferred comp) plan.” But doesn’t a supplemental plan, with a hidden tax lien create a false sense of wealth? Is $1 million in one of these plans the equivalent to a million-dollar home or a million dollars in the bank? Hardly.
Here is an example of a reality check that recently affected a public safety officer:
The retired officer, with a spouse still working, has been negotiating to purchase a secondary dream home near the couple’s grandchildren that they eventually will transition to. The couple’s combined pension and salary is $150,000. They decided to liquidate part of the officer’s $1 million deferred comp plan to fund a $350,000 deposit on the new home.[1]
Per the Charles Schwab calculator, the couple will have to liquidate $636,000 to cover the taxes just to net $350,000. The situation is such that they won’t just pay tax on the needed $350,000. For every extra dollar taken out above $350,000 to pay the tax on the $350,000 withdrawal, that extra dollar will also be subject to tax, which will require even more funds to be withdrawn. Figuratively, this former law enforcement officer will be paying taxes on the taxes, with some of the withdrawals being taxed at a 45%[2] combined federal and state rate.
Why the salesperson’s conflict of interest results in bad advice
The salesperson delivering the sales pitch (at the beginning of this article) has a conflict of interest that employees are unaware of, which incentivizes the tax vehicle the salesperson steers the employee into. Salespersons and the companies they work for are almost exclusively compensated on the assets they bring in (called “assets under management.”) Thus, in the example sales conversation, the salesperson would earn 50% more compensation if the customer invested $1,500 in a traditional plan versus $1,000 in a Roth portion of the plan.
That is why the salesperson advises you to talk to your tax advisor. He knows you won’t get around to it or you won’t pay for the tax advisor’s time. Inertia sets in. Multiply that by millions of US employees, and it adds up gigantic increased revenue benefiting the industry.
In 2019, I was sharing my concerns about this conflict with veteran Wall Street Journal columnist Jason Zweig. He commented: “At the Wall Street Journal we make up some of the smartest financial minds in the world, and we are union members. But until you mentioned this conflict, I never considered why we were advising our readers about the Roth’s advantages, yet we have never been offered the option of a Roth.” Zweig’s column appears here.[3]
The death and taxes adage needs to be updated
Over two hundred years ago, Ben Franklin said, “In this world nothing can be certain, except death and taxes.” While the saying still holds true, two things have changed:
1) Over the past 30 years, longevity has extended American’s lives, which means our nest egg has to cover more years, and
2) While taxes have not gone away, the government is looking for new sources of tax revenue increasing the likelihood American workers will be in a higher tax bracket in retirement. In this environment, are you willing to take a tax deduction now at a 35% combined federal and California rate, and bet that you will be in a lower tax bracket in 10 to 20 years?
Consider that last October, the Biden administration proposed lowering to $600, from the $10,000 threshold when banks must report cash transactions. Already starting in 2022[4], if you sell your $5,000 Warriors or Giants season tickets on Stubhub for $2,500—that’s at a loss– Stubhub will still send you a 1099-K at the end of this year. All of this mimics the Facebook/Google strategy of gathering data on us—in this case by an IRS that is desperate to extract more taxes.
Should you switch to the Roth portion of your plan? Do you want to be on the wrong side of this conflict?
Why public safety’s paycheck should be reduced
Take note, when I suggest that public safety employees would benefit from a lower paycheck, I am talking about net pay, not a reduction in salary.
If a public safety employee switched future contributions to the Roth option, they will lose the tax deduction on the contribution. In my salesperson narrative (above), the public safety officer would lose the $500 tax deduction on their $1,500 contribution—that results in a smaller paycheck— thus, the article’s title.
On the other hand, the employee could reduce their contribution to $1,000 and their paycheck would remain the same.
- The cost: loss of bragging rights on a larger supplemental pension.
- The benefit: a realistic assessment of one’s net worth, and no tax lien on their pension plan for future withdrawals.
In the short-term, the housing, stock markets, and fake coin markets have all become unpredictable as we digest the effects of the Fed’s war on inflation, China’s Zero-Covid policy, and the war in Ukraine. Individually, we cannot control the markets nor know when the exact end of the turbulence will occur. Yet, the one part of our investments’ performance that we can control is the supplemental tax vehicle we choose: Roth or traditional allocation at your plan.
Hopefully, this article has added some clarification and illustrates that the salesperson directing your 401k, 403b, or deferred comp plan is probably not putting your interests ahead of theirs.
[1] It was possible to come in with a smaller down payment and spread the costs over a greater period.
[2] The weighted average federal tax bracket on the $350,000 liquidation is approximately 28%. California will tack on 9.3% bringing the total weighted average tax rate at about 37%. Some of the withdrawal would be taxed in a higher 45% combined federal and state tax bracket.
[3] I have no longer have any affiliation with the firm I was associated with when this column appeared.
[4] Under the new law, any amount received over $600 will trigger a 1099k. This applies to sales on eBay as well.