Yeah, we just about have to concede that two things are gonna get us sooner or later—death and taxes. But sometimes we read about "tax-deferred" investments (TDIs). They sound like a pretty good concept. If we can find special TDIs for which we don't have to pay any taxes until later—much later—that seems to be a good idea. (Maybe.)
Back a couple of years ago, I got a note from Robert Klabis. He griped that a column about TDIs by Henry Wiesel (Electronic Design, March 4, 1996, p. 64F) was misleading. I tried to figure out what the problem was.
He complained that Mr. Wiesel was neglecting one vital fact. You may appear to gain advantages with TDIs because you avoid taxes early on. But when you do try to get access to your tax-deferred savings, you may have to pay tax rates even higher than when you were making the money in the first place. The effective tax rate can be as high as 28, 35, 45, or 51%. After we went around and around, I realized he was right—at least partly right. The taxes can be severe (see "TDI Calculations And The Real Tax Rate,").
So I debated with the editors at Electronic Design: Who should present Mr. Klabis' ideas to the readers, RAP or QuickLook? So here we are. (Bob, we know that nobody explains things exactly like you do. So you go right ahead and tell it like you see it.—Ed.)
Here's my theory: If you are 15, 20, or more years from retirement, investing a SMALL PART of your retirement money in TDIs is probably a good idea.
If your retirement is less than 15, 10, or 5 years away, TDIs are quite possibly a lousy idea. (That's a technical term.) In addition to the poor rates we have been discussing above, there's the possibility that some of the restrictions on TDI funds will be too tight, and you'll wish you hadn't put your money in a place where you can't get at it. In the past, these restrictions have been imposed quite arbitrarily by the IRS, Congress, and the Social Security Administration. And we don't have a lot of guarantees that they won't change them to be even MORE restrictive.
So, whether or not you are less than 20 years from retirement, you'll want to choose your tax or investment advisor very carefully. If your adviser doesn't know about these angles, you might not want to keep him or her. You might or might not want to waste your breath trying to explain it. And you might just walk away and look for a more knowledgeable advisor.
Mr. Wiesel extolled the advantages of TDIs. The mere fact that he works for Salomon Smith Barney, who would be happy to sell you either a TDI or any other kind of taxable investment, stock, or fund, is probably not a big deal. But the principle is important.
The whole concept of a TDI sounds quite nice and simple. Let's say you put $1000 into a tax-deferred account THIS year. You take $1000 before taxes, and that might avoid $310 or $360 of federal taxes, or maybe $322 or $387 (Details later). That sounds like a pretty good deal.
But let's say you retire NEXT year. Then you might have an income of $20, $30, or $40K from various investments, or perhaps some consulting work or a spouse's earned income. (Or, maybe that's a few months of salary.) You decide that you want to pull that $1000 out of your tax-deferred account. Will you get that $1000 back without much taxes? Maybe, but maybe not.
I've worked through the math of this. If you actually check out your taxes, the effective tax rate on this $1000 of tax-deferred income may be as high as 35 or 51%. It's true that the higher number tends to apply if you have a fairly high income, around $40K. If your income in retirement is down below $33K, the incremental rates may be lower. But then again, they may not.
First of all, there's no such thing as a 51% tax rate, or a 32 or 39% incremental rate—is there? Oh boy, yes there is. And here's how it works.
First of all, if you are taking itemized deductions and making over $121K per year, every dollar you earn on Line 33 can decrease the amount you can deduct on Schedule A, Line 28, at about a 3% rate. So your effective tax rate, even though you think you're in a 31% bracket, can be 31.9%.
Furthermore, if your income is over $181K (or over $90K for individuals), the Personal Exemption available on Line 37 gets decreased by the computations on the Worksheet for Line 37. So even if you THINK you're in a 36% bracket, your effective tax rate may really be up near 38.8 or 39%.
Even when you're paying your taxes on ordinary income, the computations and rates can be pretty weird. I'm NOT saying that the tax rates are so high that it's worth a lot of effort to avoid taxable income. (Hey, back 30 years ago, the tax rates could get up over 70%. A lot of people put in a lot of effort to avoid earning taxable income because the rates were so unfair! And in England, the effective tax rates used to rise as high as 19, 20, or 21 shillings on the pound, which is an incremental tax rate of 95, 100, or 105%—rather a poor incentive for working harder and earning more income, eh?)
I'm just saying that tax rates are not as easy to compute as they would seem to be. Still, if your income is up above $120K, the taxes may be more than they seem. So any of us rich folks get gouged. Maybe that's fair; maybe it's NOT. That's just how it is. And it's not just the guys with a salary over $120K. There are other kinds of income. For example, while the tax rate on capital gains may be lower now, the actual capital gains income pushes up the sum on Line 28. So the actual tax rate on capital gains may not be as low as stated.
I once had a theory about people who make a LOT of $. If you make just a bit over $70K per year, you get ONE increased paycheck at the end of the year when your FICA deductions are cut out. If you make N times that, the time you have to wait to get a bigger check is reduced by that factor of N. But you can't brag about getting that bigger check, because then everybody will know how big N is for you. The only person you could talk to is your spouse. And I wouldn't even tell my wife, because she might think that bigger check was just crying out for her to spend it!
I once thought we oughtta have a general-purpose holiday—not to brag about getting a bigger check at any particular time, but to bemoan the fact that the bigger check goes away on January 1. This holiday should be held at a time of year when we don't have enough holidays. Perhaps November 1. But I could never get anybody else interested in endorsing this "holiday," so the idea died out.
Now, let's say you're retired or semi-retired and your income is, as I said, perhaps in the range of $32 to $50K. This isn't too farfetched. If you take $680 or $1000 out of any ordinary savings account, in which you have already paid taxes on it, that makes ZERO effect on your taxes.
But if you asked to get $1000 out of a tax-deferred account, what effect does that have? Well, you have to pay the taxes NOW because you didn't want to pay them earlier.
At what rate do you pay? It all depends. But if you're getting any Social Security income at all, you may get a tax rate of 28, 40, or 51% on that $1000. That's because you have to account for this in the Social Security Benefits Worksheet that applies to line 20b on Form 1040. And if you were getting some income from Social Security and some from a tax-deferred account, your taxes may rise very quickly—to the extent that you might wish you had not taken out that money! In other words, say Uncle Sam thinks you're already making a good bit of money, plus a little social security income. If, in addition, you try to access the $1000 you saved up as tax-deferred income, Uncle Sam can take away your Social Security money so fast it will make your head spin! The taxes you pay—BECAUSE of the $1000 you took out—may be very steep.
Now, if you're only making a retirement income of $32K, $22K, or less, that tax rate may not be so bad (in 1998). It might be 15%. This could actually be a good deal.
But you've all heard the joke about the astronaut who went off in suspended animation on a long space voyage. When he got home, he called up and asked his broker how much his retirement account was worth. The broker assured him that his modest savings of $99,000 had matured into $999 billion. He was elated. Just then, the telephone operator announced, "Please deposit $99 billion for the next three minutes." If you think a dollar is going to keep its value, you're indulging in some wishful thinking.
And if you think the IRS (as instructed by Congress) is going to leave our tax rates and Social Security rates alone, with only fair "indexing," for the next 10, 20, or 30 years when you'll be getting ready to retire—gee, you sure are a trusting soul. You trust the IRS and Congress to look out for YOUR best interests? Hmm...Can I sell you a bridge?
Since the Social Security Benefit Worksheet and its tax rates of up to 51% are so well-hidden that almost nobody knows about them, I'd expect it to be the LEAST responsible place for me to be comfortable. I wouldn't expect my funds to get fair treatment without sneaky or vicious taxation. What do you think?
Do you trust the IRS (and Congress) to NOT change this? Do you expect them to leave it alone? Do you trust them to be fair with you? I don't even trust AARP to be a good watch-dog on topics as obscure as this.
So I called up Mr. Wiesel and jawed at him about this. He admitted that maybe I was technically right, in some income situations. But he also observed, "Well, I try to give investment advice that is valid for most people." I explained back to him that when I am trying to invest MY money, I want advice that is suitable for ME. To hell with what is "OK for everybody else." I don't want to be spoon-fed generalizations. And to hell with whatever the IRS is trying to bamboozle me into doing.
Then on Oct. 22, 1998, on page 64X of Electronic Design, Mr. Wiesel came out again. This time, he recommended that you invest your retirement money using "pre-tax contributions," thereby "reducing your taxable income." Yeah, but if his ideas reduce your POST-tax income when you try to access that tax-deferred money, I am not in favor of that. I've never yet been able to convince Mr. Wiesel that I am right about this. He said that after he conferred with some experts, the only case he could see for any disadvantage for TDIs was in the case of people who retire and then UN-retire.
Conversely, my investment broker agrees that I am right: Every investor must question this situation. Tax-deferred investments may be wonderfully right for some people, and horribly wrong for others.
I'm certainly not going to put any significant amounts of my money into tax-deferred income, with one good exception: My company is willing to put MATCHING funds into my 401k retirement account. They put in 40 cents on the dollar to match my tax-deferred investments up to a certain limit, such as 6% of my salary. So I definitely put in about as much money as my company will match. After that, I stop. If your company will put in matching funds, along with yours, into a 401k or similar tax-deferred fund, that's probably a good idea. You should match their matching funds.
If you're getting advice from some kind of tax or investment consultant, make sure you're talking to a knowledgeable one. Make sure the consultant has good advice tailored for YOU, not just for some "average" or "typical" person. If you find some consultants who say RAP is wrong about the 51%, tell 'em that THEY are wrong and walk out. Mail them a copy of this column from a safe distance. Then find a smart advisor.
Right now, as I am 58 years old and probably less than 10 years from retirement, I'm willing to put most of my money into various other investments. Not tax-deferred. Some are risky, some aren't risky. I try to diversify to spread the risk a little. Heck, I'm having too much fun at work. I don't really want to retire, anyhow! But if I can afford to cut back to three or four days per week, that might be nice, someday. If I save my money carefully and play it right, I may be able to go trekking every year! And I might still have a few bucks left for retirement.
I have never yet used the services of a good tax man, but that may change. I may want to DISTINGUISH between my business as an author and my business as a publisher and bookseller—not to mention my business consulting as an engineer. Hmm. Now THIS sounds complicated. Will I have to incorporate four times? Naw, I'm told that, "Piercing the corporate veil" is not a big deal, these days!
Note: All numbers refer to published 1997 or 1998 tax rates, and most are for a couple filing jointly. All bets are off for any future years. I am not able to comment on your state tax policy.
TDI Calculations And The Real Tax Rate
Why are TDIs sometimes a good idea? TDIs do NOT usually earn any higher or lower interest rate than taxable ones of comparable risk. The only advantage arises if the tax rate, when you access your TDIs, is lower than the tax rate you were paying when you avoided the tax.
My figures show that if you are retired and making $42K, and take $1K out of a tax-deferred account, the tax rate is that brutal 51%. WHY? Because Social Security payments used to be non-taxable income. But a few years back, Congress decreed that in some cases as much as 50 or 85% of your Social Security income can be taxed. And that amount increases as your ordinary income rises. So when you take that $1000 out of the tax-deferred account, your taxable income increases by $1000 and your taxable Social Security income increases by $850. You have to pay the 28% tax rate on BOTH the $1000 and the $850. It's not quite a double whammy—it's sort of 1.85 whammies. The total rate is 51.8%. You can round this off to 51 or 52%, as you prefer. You would never know this unless you have worked through the worksheet for Line 20b. And most people would never guess to look there until after they retire. That's why this tip is so timely. Thanks to Mr. Klabis for speaking out!
If you have an income of $32 to $40K, and you do the computations for Line 20b, the effective tax rate is probably more like 28%. If your income is $32, $42, or $52K, and you pull $5 or $10K out of the tax-deferred account, the effective average tax rate may be more like 32 to 42%. I'll tell you one thing: Root-canal work is less painful than trying to compute some of these tax things. Maybe this is where a tax computer program MIGHT be useful. But that's only if I'm doing 27 hypothetical tax examples. For one real example, the tax program may not be much help. I always do my taxes by hand. (I even used to use my slide rule. And I used to use simultaneous equations to compute my state and federal taxes. That may have been wrong, but nobody ever told me I was wrong.)
I think I see that if you earn your salary at high rates and plan to retire to places like Spain, Mexico, or out in the country where low income is required and the tax rates will be low, TDIs may be a pretty good idea. But if you plan to live in a city or suburbia when you retire and do a little consulting, your income may stay up in the area where the tax rates are painful.
All for now. / Comments invited!
RAP / Robert A. Pease / Engineer
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