Tax Rebate = Tax Increase for Some

The title is counter intuitive, so let me explain. The tax rebate as proposed is phased out for "high" income, for example a single with an AGI of $75,000. The $600 rebate is phased out over the $12,000 of AGI between $75,000 and $87,000. For someone with an income in this range, this is effectively a marginal tax increase of 5%. With an original marginal tax rate that's probably 5% (assuming deductions near the standard value), the effective tax rate is now 30%.

I am caught in this. If I had known about the tax rebate terms last year, I could have adjusted the amount of tax-deferred savings I converted to a Roth IRA.

I can see some merit to the argument that the tax rebate is really the US government borrowing money from the Chinese so the poor can buy Chinese goods. Either the bill for the tax rebate will have to be paid, or interest will be paid in the mean time. Probably increasing the taxes I'll have to pay on tax-deferred savings withdrawn in retirement. So in the end the extra taxes I effectively paid on part of my Roth conversions may balance out in the end.

The Retirement Reality Game Show

Welcome to the Retirement Reality Game Show. Here are the rules: you have 6 months to prepare by storing up all the supplies you need, and then you will be locked in your house for an average of 6 months, during which time additional contests will be played.

Contestant Bob buys up 6 months worth of food and other supplies, and is locked in his house. A jar with 364 black balls and one white ball is prepared. Every day, the game show host pulls out at random one ball. If a black ball is pulled, then Bob stays in his house another day. If the white ball is pulled, then Bob is released from the house.

On average, Bob will stay in the house for 183 days, which is about 6 months. But there's a 50% chance that Bob will stay in the house longer. If Bob plans his meals to last 183 days, there's a 50% chance that the viewers of the show will watch him starve.

Let's look at the graph of the probability that Bob will still be locked in the house on a certain day.
Now let's take another look at the probability of a 65-year-old surviving to a certain age.
The life expectancy graph was previously presented and explained in this post.

Aside from the fact that one graph is a simple straight line and the other is curved, these graphs are similar. If Bob prepares for an average stay in the house, he has a significant chance of starving. If you plan your retirement savings and withdrawals in retirement for an average life expectancy, there is a significant chance that you will run out of money and suffer whatever consequences follow.

While no analogy is perfect, it should put in basic terms the idea that if you prepare for the average, there's a significant chance that you will have under-prepared.

Are We Saving Optimally for Retirement?

Scott Burns has written an article entitled "We're Better Off Than We Think" on the subject of how well we're saving for retirement. He points to “Are Americans Saving ‘Optimally’ for Retirement?” which is the results of a study at the University of Wisconsin concluding that we're not so bad off.

However, as pointed out in the article
"Is There Really a Retirement Savings Crisis?" published by the Center for Retirement Research of Boston College, that for Boomers the answer may be "No, we're not saving optimally."

The Wisconsin study sampled people who were in the age range of 51 to 61 in 1992. The youngest of this group was born in 1941, 5 years before the earliest Boomer. There are a number of factors involved which will make it more difficult for Boomers than for the older generation.

Boomers will be increasingly subject to having their Social Security benefits reduced by increasing Medicare premiums. Additionally, Boomers are more likely to have their Social Security benefits taxed since the exclusion thresholds of $25,000 for a single person and $32,000 for a married couple are not indexed for inflation. If other income (including some that is not ordinarily taxable) plus 50% of your Social Security benefits exceed your exclusion level, then some or up to 85% of you Social Security benefits are added to you Adjusted Gross Income and may cause you to pay tax. The seemingly inexorable march of inflation will make it so -- even at a modest 3%/year inflation rate prices will double in 24 years (per the rule-of-72).

The defined benefit pension is going the way of the dodo bird, with more and more companies freezing pensions and/or restricting participation by new hires. A larger percentage of the people sampled by the Wisconsin study have a a pension to help with retirement than will the percentage of Boomers when we retire.

The Federal Reserve's 2004 Survey of Consumer Finances shows that the median net worth of a household in the age range of 55-64 (with retirement imminent) is $248,000. However the median net worth of the vehicles and home of this age range was over $150,000. What will happen to the price of McMansions if a large number of Boomers try to downsize by selling to the smaller Generation X following? (The basic supply Vs demand curve.) But then you have to ask whether the average boomer will want to downsize, or prefer to continue living in the same house. Would you want to sell your house in which your kids grew up and in which you've grown comfortable and move to an efficiency apartment? If you want to stay in your house, its effective net worth is reduced. Even with a reverse mortgage, you will extract only a portion of the equity during your lifetime.

Personally, I think the average Boomer is in trouble when it comes to retirement. I'm doing my best to ensure that I'm not one of them. I suspect that most people really haven't given it much thought, just assuming that a comfortable retirement automatically awaits those reaching the age of 65.

Should you convert ALL of your retirement savings to Roth?

Recently on The Simple Dollar blog, there was a discussion about future tax rates. Gail posted the comment:
"I am 56 with all my retirement funds in both Roths and traditional IRAs. I am working on a 10 year plan to complete converting all my traditional IRA funds to Roth IRAs by the time I qualify for regular Social Security. Why? Two reasons, neither very complicated. First, regardless of tax rates, I prefer knowing that I won’t have to worry about paying taxes at a time in my life when I may not be able to afford it as easily as I can now. (Same reason why I paid off the mortgage on the house). Second, assuming my investments outperform me, my children will not need to pay taxes on the Roth when they inherit and begin withdrawals.

I believe that Gail's plan to convert all of her tax-deferred retirement savings goes against her goals. While I believe that marginal tax rates will increase in the future, I also believe that there will be a certain amount of Adjusted Gross Income which is not taxed -- your personal exemptions and standard deductions. In 2007, the amount of AGI not taxed is $9800 for a single person 65 or older.

For this discussion, let's assume that Gail's investments do slightly better than the inflation rate. For this discussion, the dollar figures will be in 2007-equivalent dollars. Let's say she has $100,000 in traditional IRAs, and that her marginal tax rate is 15%. If she converts it all to Roth IRA, then it will cost her $15,000 in taxes, leaving her with $85,000. If she follows the 4% rule-of-thumb for withdrawals, then she would withdraw 4% of $85,000 or $3400 of it. And yes, all $3400 of that money would be tax free. In reality, the added taxable income from the conversion likely would put her into the 25% or higher bracket, leaving her with less money, only $3000.

Now let's say we were able to persuade Gail to leave the $100,000 in traditional IRAs. She reaches retirement with $100,000 tax-deferred, pulling out 4% or $4000 the first year. Will she pay any taxes on that amount? At first glance, $4000 is less than the $9800 sum of standard deduction plus personal exemption, so you'd expect that no taxes are due. However, the possibility of part of her Social Security being taxed should be considered. If half of her Social Security benefit + all of her other taxable income exceed $25,000 then she would have to add some of her Social Security to her Adjusted Gross Income (AGI). Let's say that she gets $1500/month or $18000/year in Social Security. Half of that ($9000) added to the $4000 equals $13,000. So none of her Social Security gets added to her AGI, and since her AGI of $4000 is less than $9800, she pays NO TAXES anyway.

But we're not done. While I expect standard deduction and personal exemption values to be indexed for inflation, the $25,000 test amount is not indexed. Let's say that over the next couple of decades, inflation doubles and erodes this to the equivalen of $12,500 in 2007 dollars. In that case, she would have $250 of Social Security added to her AGI, resulting in an AGI of $4250, none of which would be taxed.

Let's say that inflation continues for another decade and erodes the test amount to the equivalent of $6250. In that case, $4950 of Social Security will be added to the $4000 resulting in an AGI of $8950. Still less than $9800, so none of it will be taxed.

So by not converting all of her traditional IRA money to Roth IRA, Gail has extra money ($4000/year instead of $3400 or even less if taxed at greater than 15%). As far as the taxes to the heirs, if she converts the money to Roth IRA -- sure, it won't be taxed. But there will be less of it to not be taxed. Said another way, if she leaves it as tax-deferred savings, her heirs would have to pay taxes but would have more money to start with which to pay the taxes. Will they be better or worse off? Depends on Gail's tax rate now Vs their tax rate when they inherit it.

A more important consideration than optimizing taxes for your heirs is ensuring that you're not a burden on your heirs in the event that you don't die. Keeping some of your retirement savings as tax-deferred (traditional IRA or 401k) is a good strategy to increase money available for spending in retirement and reduce the likely-hood of having to depend on your heirs.

However, if you have too much money in tax-deferred savings, some or all of your Social Security benefits will be taxed. At the initial level, $1 of taxable income can result in $.50 of Social Security being taxed, and with additional income $.85 of Social Security can be taxed for each $1 of other income. This effectively raises a 15% tax rate to either 22.5% or 27.75%, and a 25% tax rate to either 37.5% or 46.25%. Not very attractive if you saved only 15% or 25% in taxes during the year that the funds were deferred. And if marginal tax rates increase, it's even worses.

Because of the taxation of Social Security benefits, I am converting tax-deferred savings to Roth IRAs. But I still intend to keep some amount of retirement savings as tax deferred.

The Power of Compounding

This article points out the power of compounding. Someone who saves $100/month for 10 years between the ages of 22 through 32 and then stops saving has more money at the age of 64 than someone who waits until the age of 32 to begin saving at the same rate and saves for 30 years. (Assuming 8% interest).

Not arguing with the math, but rather with the practicality. When I was in my 20's, $100/month would have been a significant hit to my budget, whereas now it's not such a big deal. Not only has my income increased in real terms, but there's been a good deal of inflation since then, including a few years of double-digit inflation.

These articles point out the power of compounding when it comes to savings, but leave out the power of compounding when it comes to inflation. Even at today's more modest inflation rates the compounding can be significant. At 3.5% annual inflation, the value of a dollar is halved in 20 years.

In the example given, the person who saved in his 20's was saving more valuable dollars than the person who waited until his 30's to start.

My point is not against saving, nor is it against saving while at a young age. Rather my points are that (1) effects of inflation can't be ignored and (2) your savings rate should not stay level over long periods of time.

Start young, save what you can, and adjust your savings rate for inflation and improvements in income. And hope that the earnings on your investments keep ahead of the inflation rate.

Roth Vs Tax-deferred Retirement Savings

Even before blogging became popular, Humberto Cruz has been writing on personal finance in his Savings Game column syndicated in many newspapers. He pointed out in a recent column that if you're in the same tax bracket now as you will be in retirement, there's really no tax advantage between saving in a Roth IRA and a Traditional IRA. For example, someone in a 15% tax bracket would have the same money remaining after paying taxes later-on at a 15% rate on $1000 + compounded earnings as he would paying $150 in taxes on $1000 now and collecting the remaining $850 plus the compounded earnings tax free from a Roth IRA account.

All other things being equal, I agree completely with this. The analysis is absolutely correct. However, the Roth allows you to effectively put more money in tax-advantaged savings. Provided you can come up with the money to pay the taxes this year, then instead of contributing your limit to a Traditional IRA, contributing the same amount to a Roth IRA would let you pull the higher amount plus compounded earnings out tax free in retirement.

However, the tax code is complicated and there are other considerations. So "all other things" are not always equal. While you could be in the same tax bracket in retirement, you might effectively be in a higher tax bracket.

In future posts I will be discussing the possibility of a higher effective tax bracket in retirement and how I am dealing with it.

Pay Debt or Save for Retirement

The anonymous blogger over at "My Retirement Blog" discusses this issue http://www.myretirementblog.com/pay-debt-or-save-for-retirement.html .

That blogger gives the example of John Smith, who has mended his spendthrift ways but has a $25000 debt at 15% interest to handle. His employer offers a 401k plan with dollar-for-dollar matching up to 3% of salary. The advice on the other blog is to pay off the debt first before contributing to the 401k plan because the $3750 in interest exceeds the amount that could be obtained from a company match on 3% of salary for those making less than $125K/year.

That math-challenged blogger obviously never graduated as an engineer, or any other profession requiring math skills. It's illogical to give up the 100% immediate return from the company match for a 15% return from credit card debt. Yes, I know that tax considerations can narrow the difference a bit, but not enough to overcome the difference between 100% and 15%. If John Smith is close to retirement and has no tax-deferred savings, he might not pay any taxes at all if he keeps his annual distributions low. Let's take a closer look at the numbers. I use spreadsheets to perform this type of analysis.

In order to save the $3750 in interest over the next year, John Smith need to have $25K in hand to immediately pay off the credit cards. If he did, then what's the problem? Pay off the debt and then participate in the 401K.

To round out the scenario a bit more realistically, let's say John makes $100K per year and has trimmed his expenses so he can devote $2000/month towards improving his net worth. If he applies it all to the credit card debt, after 12 payments he has reduced the balance to $3298, improving his net worth in one year by $21701, and spent $2298 in interest. So John didn't eliminate $3750 in interest payments but reduced it by a good deal.

On the other hand, if he participates in the 401K plan to get the 3% match he reduces the amount he can pay towards the debt not by the $250/month contribution but by less than that because taxes are not taken from the contribution (yet). Say John's marginal combined federal and state income tax rate is 30%. The $250 contribution reduces his take home pay by $175/month. By paying $1825/month ($2000 less $175) against the credit cards, he reduces the balance over the same one-year period to $5548, improving his after-tax net worth by $19451, and spending $2448 in interest.

By participating in the 401k, John's after-tax net worth is $2249 less after one year than it would have been had he applied the entire $2000/month to the credit card debt. But much more than offsetting the $2249 is the $6000 plus any earnings in his 401k account. Yes, John has yet to pay taxes on that money but his tax rate would need to exceed 62% to offset the difference.

The only scenario where it makes sense to pay off debt before participating in a 401K with a 100% match from the employer is if the interest rate on the debt is much, much higher. If John had payday loans, I would recommend he pay them off first.

Priorities should be (in descending order):

1. Make minimum credit card payments and build up a small emergency fund, say $1000.
2. Contribute to your 401k to get the company match, even if the match is only 50 cents for every dollar.
3. Pay off high interest credit card debt.
4. Contribute the maximum to a Roth IRA, and build up your emergency fund to at least 3 months expenses. In John's case I'd slow down paying on the credit card debt after knocking the balance down and fund a Roth IRA for tax year 2007 by April 15, 2008. Reason being the opportunity cost of not contributing to the Roth IRA.
5. Consider longer term savings options, such as increasing your 401k contributions if you are close to retirement and have a low balance, or paying a bit ahead on your mortgage if you plan to stay in your house after retiring.

My engineering mindset led me to analyze this a bit deeper than a shot from the hip as the other blogger apparently did, and I came up with a better answer.