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“I tried paying my income taxes with a smile; however, they wanted cash.”

| January 09, 2013
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Warning, I’m about to share my observations about how your hard earned savings and the US tax code interact.

At the very mention of the word “tax” I need to state up, front that I am not a licensed tax professional and you shouldn’t take any of the following to be tax advice. Please, get your tax advice from a licensed tax professional.

My goal is to simply share a few observations I have picked up during my 30 year career in the world of finance and help you see how things interact with a simple analysis. 

Fact:  The United States tax code is complicated. In 1913, the “temporary” federal income tax code started with about 400 pages. In 99 years, it’s grown to over 72,500 pages. That averages 2 new pages a day, every day, for the last 99 years.

But, what isn’t so complicated is our options for tax treatment of our savings. In my observation, the IRS gives us five common “income” and “capital gains” tax treatments;

TreatmentDescription 

1

Defer income tax today, pay tax on all withdrawals (401k)

2

Pay income tax today, tax free gains (Roth)

3

Pay income tax today, defer tax on capital gains until sold (Equities held 1 year +)

4

Pay income tax today, defer tax on ordinary income gains until withdrawn (Annuities)

5

Pay income tax today, pay tax on ordinary income gains every year (CD’s)

 

Warning, to keep this article semi-under control, I’m not discussing Dividend Income, Short Term Capital Gains, Precious Metal “Collectible” or about a zillion other possible treatments found in those 72,500 pages of tax code – I’m just sticking to what I think most Americans actually experience.

So, which Treatment will yield the most growth on our money?

It’s impossible to answer until all the years go by and we can see what actually happened with investment returns, withdrawals, tax code changes, and tax rates for each and every year of our life and maybe even our children’s and grandchildren’s lives.

Well, if we can’t know upfront, how are we supposed to choose intelligently where to save our money?

Let’s look at some math to shed a little light on the question. Assume we have $100,000 of pre- income tax savings, invested it for 30 years, earned 5% annually, had an annual 30% ordinary income tax rate, and an annual 20% capital gains tax rate.

The following table represents the mathematical “after tax” values in 30 years:

Treatment

After Tax Value

 

30% Tax Rate 1->30

 

1

302,536

2

302,536

3

256,029

4

232,775

5

196,476

A few observations:

  1. Plans 1 & 2 result in the highest values and are equal given a constant annual tax rate
    1. In my observation, this is a common misunderstood truth
    2. While deferral  sounds superior, with tax rates held constant, early tax and then tax free is just as good
    3. Plan 3 results in a lower value due to early taxation and later capital gain tax on earnings (-15% lower)
    4. Plan 4 results in a lower value due to early taxation and later ordinary income tax on earnings (-23% lower)
    5. Plan 5 results in the lowest value due to early taxation and annual ordinary income tax on earnings (-35% lower)

How sensitive are the results to future tax rate changes? You be the judge.

Assume three scenarios: constant 30% tax, a 25% decrease in years 16 through 30, and then a 25% increase in years 16 through 30.

Treatment

After Tax Value:

30% Tax Rate

 1->30

After Tax Value:

 

30% Tax Rate

1->15

22.5% Tax Rate
16->30

After Tax Value:

30% Tax Rate

1->15

37.5 % Tax Rate
16->30

1

302,536

334,951

270,121

2

302,536

302,536

302,536

3

256,029

256,029

256,029

4

232,775

250,215

215,335

5

196,476

207,429

186,064

 

Three points:

  1. If taxes go up or go down, the first two treatments still yield higher values than the next three
  2. If taxes go down, the first treatment yields the highest value
  3. If taxes go up, the second treatment yields the highest value

Hence, we can see why most people pick treatment 1 or 2.

But, guess who else has done the math? That’s right, our elected officials. Because of the financial benefits of Treatment 1 and 2, they created all kinds of complicated contribution limits. No one in the republic gets too much of a good thing!

For each of us, our choice depends on our individual saving amounts, contribution limits, investment portfolios, tax rate outlooks, need for “penalty free” access to our savings pre-retirement, college financial aid visibility, and many more. Often, we end up with multiple treatments due to limits and other considerations. But knowing the math means knowing the truth about how the tax interacts and impacts our savings over time.

In summary:

  • The Bad News: It’s a complicated tax code.
  • The Really Bad News: It takes a complicated ”individualized” analysis to make informed choices.

So, to make your decision, I’d suggest your either study hard, or get some help. And yes, this analysis is something I do for clients and their qualified tax advisors. So while I’m shamelessly plugging, I hope I helped you see some of the reality of how complicated the relationship is between our savings and the tax code.

Written by Mark Guthrie
Principal – Westface Financial and Insurance Services

Mark Guthrie is a Registered Representative offering Securities through The O.N. Equity Sales Company, Member FINRA/SIPC , One Financial Way, Cincinnati, Ohio 45242 (513) 794-6794

Investment advisory services offered by Mark Guthrie through O.N. Investment Management Company.

Tax and/or legal advice is not offered by Mark Guthrie. Please consult with your tax professional for additional guidance regarding tax-related matters.

Photo Credit: Philip Taylor PT

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