By Bob Wood, MMNS
Investors arranging for their annual pre-April 15 visit with an accountant should expect conversations about deferring taxes by using profit sharing, IRA or other tax-saving accounts. In my opinion, this solution is a classic case of â€˜â€™Pay me now, or pay me later.â€™â€™ I continue to believe that tax-deferred savings accounts are a bad idea for most.
I am well aware that my position on tax-deferred accounts is a minority opinion, and I can clearly imagine the shock on the face of any accountant reading this column. Yet I believe that the case for tax-deferred accounts is weak, at best.
To illustrate my position, letâ€™s begin with the strongest argument typically made in favor of tax-deferred accounts. Yes, any accountant can run a set of calculations to show clearly how your savings will grow faster in a tax-deferred account. I do not argue that point at all. What I do argue is whether a saver will be any better off, in net terms, than he would have been using taxable alternatives.
To create your own visual to see what I mean, youâ€™ll need a quarter, a piece of paper and a pen. Simply trace a circle around the quarter, and label the circle as your taxable account. Now draw a larger circle around the first one. Label the larger circle your tax-deferred account. To complete the illustration, color in the area between the two circles. What you have just done is illustrate how much of your savings account belongs to your partner. In this case, your â€œpartnerâ€ is the entity who owns that portion of your account.
Remember, the term â€œtax-deferredâ€ does not mean â€œtax exempt.â€ At some point in the future, when you withdraw money from your account, a portion of each withdrawal belongs to your partner. Your partner, obviously, is the federal government.
Yes, in a tax-deferred account, your savings will grow larger. But that incremental increase may not belong to you. Nor is it likely that you will become any richer when you begin taking money from this account.
The savings projections furnished by your accountant rely on the validity of the assumptions used to create them. One of the most obviously flawed assumptions typically used is that, during retirement, youâ€™ll find yourself in a lower tax bracket.
This idea assumes that your income will be lower in retirement than during your last years of work. And that obviously leads to the assumption that you will be spending less money during retirement than during your working years.
Sit back for a moment and imagine how much of your current spending you could reduce in your first year of retirement. Could you cut current spending by 10%? Or 20%? What would you cut back on first?
Then, think about what you will do with all the time no longer devoted to working or traveling back and forth to the office? Will you sit around the house watching TV, reading old books or lounging on your favorite park bench?
A good exercise that helps immensely as you plan for retirement is asking people who are already retired how much less they spend now than when they were working. When I have asked this question, I typically hear that spending does not decrease during the first years of retirement. In fact, more than likely, spending will remain the same or even rise for active retirees. Letâ€™s face it, sitting around the house watching television is not what most of us have in mind for those first retirement years.
If you get similar answers after asking retirees about changes in their spending and lifestyles, it becomes apparent that your retirement income should be close to what it is while you are still employed. So how will your tax rate fall if your retirement income and spending remain similar to those of pre-retirement? If you would prefer to maintain your current standard of living during retirement, the illustration you created with the two circles begins to look more realistic than the projections offered by your accountant.
Other economic problems are made evident as we continue along the current presidential election cycle and hear more about the leading candidatesâ€™ positions. For Wall Street and those in the financial media, hearing the candidatesâ€™ short list of â€œscaryâ€ words and terms about the economy can be useful in furthering their agenda items. Obviously, their agenda items do not often match ours. When they do not, we can expect to hear some of those scary words repeated, and terms such as â€œisolationist,â€™â€™ â€˜â€™socialized medicine,â€™â€™ and â€˜â€™populismâ€™â€™ are used frequently. Perhaps the intent is to make us think that some things that are actually good for us are really bad — and should be avoided at all cost.
Populism refers to an agenda that makes more sense for the majority than it does for the minority in power. That minority has prospered exceedingly well during the Bush administrationâ€™s time in office. The last thing that minority would want is a change in the economic environment.
So when any candidate talks about ideas designed to benefit the poor or middle class, they are quickly attacked as some form of socialism or populism. That some of those ideas are well entrenched and central themes of economies around the world, often more healthy than ours, does not seem to matter.
The problem for those in the privileged minority is that anything that smacks of being a positive for the greater good is likely to come at their expense. And naturally, they will fight those ideas using all the alarmist rhetoric they can muster. But perhaps the odds are now against them, since the middle class has found itself on the short end of every economic bargain pushed through by our Government — at Wall Streetâ€™s urging.
Given the unpopularity of the current administration, seeing a Democrat in the White House in 2009 seems almost assured. The new administration will, of course, find itself beholden to its base, the greater population and common good. Perhaps that may mean not only an end to the disastrous tax cutting policies of the current administration but also an increase in social spending programs. But the big problem with this plan is: our government is bankrupt!
The national debt has exploded to well over $9 trillion during Mr. Bushâ€™s time in office. He is the poster boy for reckless spending. As a country, we must now borrow more than $2 billion each and every day to keep our economy from shutting down.
We are experiencing a slump in the housing market, while state and local governments get squeezed as expenses exceed income from taxes. Surely, I am not the only one who expects tax rates to rise in the future.
So what happens to saversâ€™ plan for deferred taxes at todayâ€™s rates when they find higher tax rates assessed during retirement — when that money is needed? The possibility exists — and I fully expect it — that your illustration with the two circles might prove overly optimistic. Think too of required minimum distributions and what those will look like as you advance in age. Ask your accountant what your income might be when you are 80 years old and required to take far more from your accounts than needed to fund your lifestyle. You will forever remain in the highest tax bracket!
Letâ€™s look at an illustration for that possibility, again using those two circles. This time, color in not only the space between the two circles but also a small portion of the outer edge of the smaller circle. Your tax-deferred savings account may well end up looking like this, regardless of whether we find a Democrat or Republican in the White House in 2009.
Today, an article in my local newspaper says that the bond rating agency, Moodyâ€™s, predicts that the U. S. government may lose its AAA bond rating within the next 10 years, due largely to its projected obligations for social programs like Social Security and Medicare. Two possible remedies can solve this problem. We can either cut spending on those programs or raise taxes to fund them at current levels.
Can you imagine any politician telling us that our retirement benefits will be cut? Can you picture any politician announcing that tax rates will have to rise, especially for the wealthiest among us?
In the first scenario, living standards for a very large portion of the country would be affected negatively. In the second scenario, levying higher tax rates against the rich, is like raising taxes on cigarettes: very few are affected. The majority, which doesnâ€™t smoke, will eagerly approve raising taxes that it will not pay. Most voters would also approve raising taxes at top marginal brackets, since, of course, those higher tax rates will not affect them. And since the rich wonâ€™t really suffer or see a diminution of their lifestyles from higher taxes, this looks to be the least painful alternative.
In short, both populism and the reality of our current fiscal situation certainly demand higher revenues flowing into government coffers in the very near future. Since your partner in your tax-deferred savings account will be reaching into that account for a greater share as time goes on, can you see my problem with using this type of savings option?
As an investor in a taxable account, I feel that I will be better able to manage my long-term tax costs by taking money from my account to pay lower capital gains rates. And I would much rather pay higher taxes while I am working than when I am retired and needing to make sure that every dollar counts.
Have a great week.
Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., email@example.com.