Roanoke Times
Copyright (c) 1995, Landmark Communications, Inc.
DATE: MONDAY, May 30, 1994 TAG: 9405310126
SECTION: MONEY PAGE: A-8 EDITION: METRO
SOURCE: By MAG POFF STAFF WRITER
DATELINE: LENGTH: Medium
With the recent rise in personal income tax rates, however, some experts have begun to question whether it is still worth deferring income into IRAs, 401(k) plans or other retirement vehicles.
The Institute of Certified Financial Planners said these experts believe that tax rates will continue to rise to pay for the ballooning federal deficit and a faltering Social Security system.
Consequently, they argue, many people may be deferring tax dollars at today's tax rates only to face the nasty surprise of paying substantially higher tax rates on the money years later when they withdraw the funds for retirement. The common wisdom has held that those who save for retirement will pay those taxes at lower rates because of smaller incomes.
So, is it still worthwhile to defer taxes?
For most people under most circumstances, the institute said, the answer is yes. But like anything involving taxes and investments, it pays to run the numbers.
The planners gave the following example:
Suppose you put $1,000 into a tax-deferred vehicle each year for 40 years, earning a modest 6 percent a year. Your average tax rate during those 40 years is 25 percent.
At the end of 40 years, the account will have grown to $154,760. After taxes of 25 percent, you would have $116,070 in spendable dollars.
If you put the same $1,000 into taxable investments earning 6 percent, you will accumulate $80,270 in spendable dollars after 40 years.
Why the $35,800 difference?
Because the tax-deferred account is earning money on funds that otherwise would have gone to the Internal Revenue Service. In fact, the higher your average tax rate during those 40 years and the greater the rate of return, the greater the differential.
This scenario assumes your average tax rate is no higher after you retire than before. But what if your retirement tax rate is higher, as some commentators predict? In fact, the tax rate for many retired people tends to be higher than it was during their early, lower income years.
Here's when you may need to run the numbers with a certified financial planner or other financial professional:
If you think the tax rate will jump dramatically.
In the example, however, the average tax rate during retirement would have to nearly double before the tax-deferred account would lose its advantage.
Furthermore, the scenario does not take into account the fact that one probably would not withdraw all the tax-deferred funds at once. A portion would continue to grow tax deferred.
If you can earn substantially higher returns in an investment.
Reinvesting profits in a healthy small business, for example, could earn a much higher return than alternative tax-deferred investments. This difference could more than compensate for the drag of taxes.
If you are accumulating substantial tax-deferred funds.
You may be vulnerable to the 15 percent "excess distribution" or "excess accumulation" tax on tax-deferred funds, negating some of the value of deferral.
If your income comes primarily from capital gains.
The top capital gains rate is 28 percent vs. a top federal income tax rate of 39.6 percent. It may be cheaper to pay taxes as you go.
If you anticipate making early withdrawals.
If you withdraw money before the age of 591/2, say to start up your own business, the 10 percent early withdrawal penalty could wipe out the advantage of tax deferral.
Of course, it's anybody's guess whether tax rates will rise significantly in the future.
Regardless, for many people tax deferred plans, especially employer-sponsored plans, "force" them to save, the planners said. Some plans, such as the popular 401(k), have the added advantage of receiving employer contributions.
Without tax deferral, many people would set aside little or nothing for retirement. Retirement would then no longer be a tax issue, but a survival issue.
by CNB