Wednesday, August 8, 2012

IS TAX-DEFERRED TO BE PREFERRED?

When I was putting money into my conventional Individual Retirement Account [IRA], I was pleased that it lowered my taxable income for that year, although I realized that it would be taxed when I took it out later, and could even be taxed at a penalty rate if I did not meet certain requirements if I did not wait until I was 59 ½.

Is tax deferral really a bargain?

Conventional IRA You put, say, \$1000 into the IRA in a year when your tax bracket is, for example, 30%. The rest of your income is taxed as usual, but this \$1000 goes untaxed into the IRA. Imagine it grows at a constant 6% per year for 24 years, and thus approximately quadruples to \$4000, at which time you take it out and it is taxed as income. If your tax bracket is still 30%, then you keep (1-0.30)x(\$4000)=\$2800 to use as you please.

Roth IRAWhat if your original \$1000 had been taxed at 30%, but you were allowed to withdraw it later without paying tax on the withdrawal? If the (1-0.30)x\$1000=\$700 grew at the same 6% per year for 24 years, it would quadruple, and you would end up with \$2800 to use as you please…exactly where you would have ended up with the tax-deferred account. If you can trust the government not to change the law and tax it again on the way out.

Taxable Bond What if your original \$1000 had been taxed at 30% so that you only had \$700 to put into a 6%/year bond, and then the interest was taxed yearly at 30%, so that it was really only earning you a net of (6%/year)x(1-0.30)=4.2%/year? After those same 24 years you would have ended up with (\$700)x(1+0.042)x(1+0.042)…, which equals (\$700)x(2.684)=\$1878, almost \$1000 less than our other two examples.

We see that tax-deferral is not a magic bullet, but it can better than having no tax preference at all.

A Closer LookWe have assumed that your tax bracket has been the same at the start and the end of the 24-year period, 30%. If that is true, then the final value of your account when you withdraw it is the same whether you are taxed on the money before you invest it or only when you withdraw it.

Will your tax bracket be higher or lower a couple of decades into the future? No one knows. You are taking your chances. Government tends to grow, and taxes tend to be raised, though there are periods in which “loopholes” are closed and taxes reduced. If what you want to do with the money comes to be considered a “loophole,” you may pay a penalty on withdrawal of your money when you want to withdraw it. Do you feel lucky?

As we age, we pay off our mortgages and our children become adults, so two common tax deductions are gone, leaving us in a higher tax bracket.

Eventually, we retire, and our incomes usually are reduced, leaving us in a lower tax bracket, if the brackets have not been changed by law during this period. If we have significant medical expenses, they can become heavy enough to become tax deductions, too, also lowering our tax bracket.

Tax-deferral is generally better than no special tax treatment at all, but it is not the bargain I once thought it was.

Still, I was happy to have that IRA, as my employer had added its contributions to my own. I was especially happy to have that IRA last year when I cashed it in, to cover unusually high medical expenses we had incurred.