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Posted at 10:08 AM ET, 04/13/2011

Is tax deferral dead? Readers react

My March 30 column on this question generated lots of mail — many folks said they’d been thinking about precisely the question I raised.  Interestingly, smart folks seemed divided on the issue of whether deferring still makes sense if you think tax rates will be higher in the future. As promised, here is a sampling from the variety of thoughtful reactions. For what its worth, I’ve decided to keep deferring via retirement accounts this year, but I may change my mind in the future.  A lot depends on your situation and numerous specific factors, and for many people it’s close call. I’ll still be thinking this through in the year ahead.


From a financial adviser:  I started telling my financial clients to stop deferring in 2005, when I became clear that whoever was so unfortunate as to succeed Bush as president would have to raise taxes. It hasn’t happened yet. But it will, as it becomes more clear that we are on an unsustainable budgetary path and that we cannot cut our way out of this problem.

From a younger worker:  I'm a young working professional, and I have moved as much of my 401(k) and IRA savings as legally allowable into Roths. In my view, this allows me to pack more punch with the legally allowable limits, and there is such a strange consensus in our country that income is the only moral activity that can be taxed, we can be confident that future deficits will be closed in part through even higher marginal income tax rates. My main concern is that future politicians will say “Let’s tax the rich,” see the huge pot in people’s Roth accounts, and then try to confiscate that, as happened in Argentina. It’s tough to predict what will happen, but my hope is that future politicians find a way to sensibly lower entitlement benefits, broaden the tax base, and tax activities like consumption, carbon use, and vices, instead of the endless mantra of “tax the rich.” I'm not confident that future politicians will have this wisdom, though.

From a retiree: I can provide a concrete example of why not to defer taxes. I am retired, on Social Security and have a decent retirement portfolio made up primarily of tax-advantaged investments — 401(k) and IRAs. I'm doing some financial analysis and looking at the required minimum distributions I will have to start making when I’m 70.5 years old. The RMDs will mean 85% of my Social Security will get taxed along with the RMDs themselves. Instead of taking Social Security at 64 I should have started converting the IRAs to Roth IRAs at 60 and paying the taxes on the conversions at the prevailing rates. Then, at 70, I could draw Social Security and have a much smaller amount of RMDs and a larger Social Security amount. Risks obviously are not living until 70 or Congress changing Social Security rules. Bigger risk is the tax rates going up, which I believe they have to do. Biggest risk of course is that Congress will change the tax treatment afforded to Roth IRAs. Something along the lines of how Social Security payments are currently taxed. The exemption of $32,000 that is allowed has never been changed, or indexed, to account for increases in the amount of Social Security paid out. Roth tax treatment could be changed so that higher incomes have to pay taxes on a portion of the distribution. Sort of perverse in that I will have to take RMDs, the result of which will mean my Social Security payments will also be taxed.

My solution is to start converting now even though I take an extra tax hit on my Social Security payments — and hope the rules stay the same. I was thinking about redoing SS but Congress shut that avenue off recently. I have written some analysis programs to determine how much to convert, trying to minimize the tax hit. Key assumption is that tax rates will go up — probably before I get all that I want to convert done. Lesson: Don't assume postponing taxes is always the way to go. Sort of like buy and hold in the stock market.

From a financial adviser: You have uncovered something that has been unknown to the average investor and many financial consultants as well. Tax deferral is no big deal and may actually be worse than paying taxes now depending upon the assumptions that you make.

A $1,000 deposit in your IRA will grow to $3,869 in 20 years at 7%.  Assume that you pay tax of 25% and you are left with $2,902. What if you paid the tax up front of $250 and invested at 7% for 20 years. You get the same $2,902. It is true that does not account for the tax on the earnings, but right now the tax on dividends and capital gains is 15%.  Given the opportunity to shelter gains by writing off losses against gains the actual tax is likely significantly less than 15%. As you point out, the likelihood that tax rates stay at this level is crazy. ( My hope, as a centrist capitalist, much like you, Matt, is that we raise ordinary income tax rates for the very wealthy, take away ridiculous deductions like mortgage interest on second homes; stop giving social safety net benefits to those who do not need them, but keep the capital gains rate low.  I am dreaming.)

From a financial-planning point of view there is an additional problem. The “lower upper class” as you call them, turns 50, having earned a very good income for many years; bought the nice house; always two nice cars; private school for kids; Ivy League colleges and always funded their retirement plans to the max. Now they have seven figures in the retirement account, no personal cash and a lot of debt. Had they deferred less and paid some tax, they would likely have significantly less debt. We should not ignore the impact of those debt payments on the big financial picture.

On the other hand there are some good reasons to defer that have nothing to do with tax code per se. First, any employee should take full advantage of an employer match on a 401(k). Second, the big fallacy in my numerical example above is that our hypothetical saver actually will save the $750 per year and will not use it on a bigger vacation, etc. If we take the $1000 out of his paycheck and put it an account that he cannot touch until 59½ , he may be better off. Human nature is human nature.  Additionally, if indeed, the deferred assets do not have to be touched in retirement, the assets can be left to heirs who can continue the tax deferral over their lifetime as well with only minimal withdraw requirements.

The best tax, financial and social strategy is to leave as much as you can in the tax deferred account even through retirement. Leave the entire account to a public foundation in which your children are donor advisers. No income, estate or inheritance tax will have been paid; you will have left your children an awesome legacy and responsibility; it will introduce your children to some great people who have devoted their lives to great causes; and they will be invited to more black-tie events than they will ever want to attend.

Bottom line: You alluded to it in the article. Tax deferral can be good, but is not the panacea that it is made out to be. As with most things, moderation is likely the best strategy.

From a divorced entrepreneur: As an interesting note, however, one must consider all forms of income “taxation.” For about half of us (the divorced half), it is effectively “F + S + L + A + C + E - Ded*rate” where F = federal income tax rate, S = state income tax rate, l = local income tax rate, A = alimony, C = child support, E = employment tax rate (both sides) and Ded*rate = tax value of deductions.

Mine, for example, is 35 + 5 + 0 + 0 + ~17 + ~10, accounting for the phase-out of FICA above 105K. That is, by the way, more than 2/3. But remember, while F and S will climb over the years, A and C go down over time. So it’s a complex balance!


By  |  10:08 AM ET, 04/13/2011

 
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