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Posted by Hank Arnold (MVP) on September 13, 2007, 5:44 am
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R. C. White wrote:
>
> Nope. Since I never was a fan of 401(k) anyhow, and I've never had one,
> and never had a client with one since I retired and started using
> Quicken - I don't really know what you guys are talking about. ;^}
>
I'm curious as to why you don't like 401K's. Even if the choices are
limited, the employer match makes it a very good vehicle.....
--
Regards,
Hank Arnold
Microsoft MVP
Windows Server - Directory Services
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Posted by R. C. White on September 13, 2007, 12:21 pm
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Hi, Hank.
It's a very fine point, but I didn't say I "don't like" them, just that I'm
"not a fan". They're OK and they can provide motivation for someone who
would not have the persistent willpower to save. And if the employer
matches some or all of your contributions, then that is a clear bonus to
you. But the tax deferral can be an illusory savings.
Why illusory? Because of simple arithmetic that we learned in grade school.
When we are dealing with subtraction and division, the SEQUENCE of the
calculations makes a major difference. (4 - 3 gives a much different answer
than 3 -4; ditto 4 / 3 versus 3 / 4) But with addition and multiplication,
the order doesn't matter. (4 + 3 equals 3 + 4; 4 * 3 equals 3 * 4) When we
mix the operations, we have to observe the order to see what results to
expect.
To work out detailed examples would take much more time than I'm willing to
spend on this today. But for a quickie: What's the difference between:
$2,000 (per year) * 20 (years of contributions) = $40,000; minus 25%
(assumed tax rate) leaves $30,000; versus
$2,000 - 25% (pay-as-you-earn tax) = $1,500 * 20 (years) = $30,000?
This obviously leaves out three key factors: (1) investment income over 20
years; (2) inflation over 20 years; and (3) varying tax rates.
1. Obviously, $2,000 will earn more than $1,500 (if invested similarly),
and 20 years of compounding of those earnings will produce a larger result.
(At 6% APY, $73,571 vs. $55,178) But the larger fund is taxable when
received; the smaller one is not; after 25% tax on the larger amount, the
net result will be equal to the smaller one.
2. Inflation matters - but it applies whether the tax is paid now or paid
later. Its result can be calculated by simply adjusting the APY by the
inflation rate. The numbers will change, but the ratio will stay the same -
and the two final numbers will be equal.
3. Tax rates? That's the big unknown, and it can make a major difference
in the final results! But how do you predict tax rates 20 years from now,
and year by year over that 20 years? I can't do it, and I doubt that you
can. My quickie example assumes that the tax rate remains steady, and that
is probably not likely. Not only can Congress change the rates, but life
circumstances can change them, too.
The popular press - and most people - don't understand our progressive tax
rates and the effects that they have on all of us. Most people don't even
understand tax brackets on their own income! They think that someone in the
25% bracket will always pay that rate on additional income or save that rate
on deductions. But, as the very name "bracket" implies, that rate applies
ONLY to income within an upper and lower limit. If a 25% taxpayer gets a
$1,000 bonus, he probably will pay $250 on it. But if he gets a $100,000
bonus (or lottery winning), his tax will probably be more. If he is already
at the top of the 25% bracket ($123,700 TAXABLE income - that's AFTER
deductions and exemptions! And I'm looking at the 2006 rates for joint
returns: http://www.irs.gov/pub/irs-pdf/i1040gi.pdf), then the bonus gets
taxed at 28% on the first $64,750 ($18,130) and 33% on the top $35,250
($11,633) for a total of $29,763, or nearly 30%, not the 25% that he might
have been using in his planning. On the other hand, a $1,000 deduction
would save him $250, all right, but a $100,000 deduction would probably save
him only $18,109, the tax on the bottom $100,000, most of which fits into
less-than-25% brackets, for an effective rate of about 18%.
MANY other factors can affect the actual tax rates that must be assumed to
make meaningful calculations. The essential factors to keep in mind is that
more income causes the tax rates to increase, while less income (or more
deductions) causes rates to decline, but the increases and decreases are NOT
LINEAR! They go UP faster than they go DOWN. As we just illustrated, a
$100,000 bonus could cost 30%, while an equal loss would save only 18%, both
for someone who is "in the 25% bracket".
For many taxpayers, 401(k)/IRA/SEP, etc., are great. But I'm not a fan,
I've never used Quicken to account for one, and I know very little about
them. So I really should keep my nose out of discussions of them.
RC
--
R. C. White, CPA
San Marcos, TX
(Retired. No longer licensed to practice public accounting.)
rc@grandecom.net
Microsoft Windows MVP
(Currently running Vista Ultimate x64)
> R. C. White wrote:
>>
>> Nope. Since I never was a fan of 401(k) anyhow, and I've never had one,
>> and never had a client with one since I retired and started using
>> Quicken - I don't really know what you guys are talking about. ;^}
>>
>
> I'm curious as to why you don't like 401K's. Even if the choices are
> limited, the employer match makes it a very good vehicle.....
>
>
> --
>
> Regards,
> Hank Arnold
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Posted by Bob Wang on September 13, 2007, 12:47 pm
Please log in for more thread options RC:
Thanks for another excellent exposition.
I would add that the "standard" argument for deferring taxes in 401(k)s is
that most people will earn less in retirement than while actually working.
Of course, as you said, nobody can predict what tax rates will ACTUALLY BE
in retirement.
Employer match is a bonus, and there is one subtle advantage to being in an
employer-sponsored plan.
Employees with small 401(k)s can participate in funds that usually require
large buy-ins.
e.g. Fidelity's FRTXX usually requires a minimum of $100,000, but can be the
default in a large employer plan.
Of course, people who can buy into FRTXX anyway, probably have the
discipline to save outside of 401(k)s ;-)
Bob
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Posted by John Oliver on September 13, 2007, 1:20 pm
Please log in for more thread options On Thu, 13 Sep 2007 10:47:04 -0600, Bob Wang wrote:
> RC:
>
> Thanks for another excellent exposition.
> I would add that the "standard" argument for deferring taxes in 401(k)s is
> that most people will earn less in retirement than while actually working.
> Of course, as you said, nobody can predict what tax rates will ACTUALLY BE
> in retirement.
This is why my primary retirement account is my Roth IRA. But, of
course, even with that, there's no guarantee that the Socialists in DC
will decide to tax the gains, or what the hell, go ahead and double-tax
that money... after all, it isn't fair that I might retire with hundreds
of thousands of dollars when there are some poor, destitute crackheads
that really should get that money. But what else can we do? Bury the
money in the back yard? Buy krugerrands? Stock up on ammo and MREs?
But no way am I giving up an automatic 10% return on my money with the
401(k).
--
* John Oliver http://www.john-oliver.net/ *
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Posted by Bob Wang on September 13, 2007, 7:42 pm
Please log in for more thread options "Socialists in DC"
Heh.
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