November Newsletter
Welcome to the Desert of the Real—
Real Investment Returns in a Dry Season
November 2005 Copyright Robert C. Feightner
Welcome to the Desert of the Real.[1] This issue of the newsletter is the sixth in an ongoing series. It is free of charge and directed to anyone who wants better investment results.
The Only Thing Inevitable is the Author’ s Use of the Trite Aphorism: “The Only Things that are Inevitable are Death and Taxes?”
Only one subject will figure prominently in this newsletter. The topic will be the Roth IRA and how to employ it effectively in your retirement planning. The other topic, currently on hold, would have been death. Well, death only for the uber-wealthy, as the topic was to have been the Federal Estate and Gift Tax.[2]
Before we take up the Roth IRA, let’s do a review of the Traditional IRA. A Traditional IRA, around since the 1970s, allows an income earner to put $4,000 into a tax-deferred account in 2005. ($4,500 if you are age 50 or over.) Subject to certain restrictions, the IRA account holder then has his adjusted gross income reduced by the amount of his IRA contribution. Basically, the Traditional IRA contribution goes in tax-free. The returns on the IRA account grow tax-free until the account holder withdraws funds from the account. When she withdraws funds, the withdrawals are then taxed at her ordinary income tax rate.
A Traditional IRA holder cannot, subject to certain exceptions, make withdrawals prior to age 59-1/2. A Traditional IRA holder must begin withdrawals at age 70-1/2. Further, the beneficiary of the IRA, upon the account holder’s death, must begin to make withdrawals. In short, a Traditional IRA holder defers, but does not eliminate taxes on the account returns. Sounds good so far, so what’s the catch?
Here are the catches. The intervening years between the 1970s and today have seen huge changes in the tax code that have reduced the anticipated benefits of the Traditional IRA. Also, a key assumption that underlay the rationale for the Traditional IRA was apparently incorrect. Let’s take a look at what went wrong:
1. Tax Bracket Compression. When the IRA law was enacted, individual tax rates were high. Marginal rates could be very high[3]. And there were numerous tax brackets. If you were in a high tax bracket before retirement, you could generally assume you would fall into a lower tax bracket after retirement and pay lower taxes on your IRA withdrawals. Your Traditional IRA would not eliminate taxes, but it would reduce them.
Congress, in the intervening years, has cut top rates and reduced the number of tax brackets. There are now six federal tax brackets, four of which apply to married filers earning between $7,300 to $163, 225, the great majority of taxpayers. These rates are 15, 25, 28 and 33%. And if you listen to the political rhetoric, the intent is to compress these rates further and continue to chip away at deductions and exemptions. As tax rates compress, there are less tax savings available for your traditional IRA withdrawals. And if the flat-tax advocates get their way, there would be no bracket reductions to lower your IRA withdrawals.[4]
2. What Cut in Retirement Income? In the 1970s it was generally assumed that nearly all Americans would have reduced income in retirement. Few Americans had amassed large retirement savings. Most folks relied on Social Security and a pension. Although the data is somewhat scant, economists are finding that retirees with Traditional IRAs are not taking substantial cuts in income in at least their first few years of retirement. This could be a confluence of two factors, however. One is the result of tax bracket compression set out in 1, above. The other factor could be that individuals who took advantage of Traditional IRAs and are now retiring are high-net worth individuals that initially saw the value of Traditional IRAs in the 1970s and 1980s.
And it should additionally be considered that people who began investing in the late 1970s and early 1980s rode the strongest Secular Bull Market in history to unprecedented gains. When it rains, says the versatile aphorism, it pours.
If there are so many things wrong with the Traditional IRA, what is right with the Roth IRA?
The Author is Temporarily out of Alliterative Allusions and Terrific Tropes
The first and foremost advantage of the Roth IRA is that the proceeds are tax-free. All of the returns will be tax-free. The account holder’s contributions are after-tax, so there is not upfront savings. But the long-term benefit far outweighs up front taxability. The only other concern with the Roth IRA is that high-income individuals cannot take advantage of a ROTH. Below are the income limitations:
Single Filer: Complete IRA contributions up to $95,000 Adjusted Gross Income (AGI). Partial Contribitions to $110,000 AGI.
Married Filers: Complete IRA Contributions up to $150,000 AGI. Partial Contributions up to $160,000.
Some Examples
Josh and Jenna White are 35 years old. They plan to retire at 35, so they have 30 years until retirement. They do not have a pension plan at work. They can either contribute $8,000 to a Traditional IRA or $8,000 to a Roth IRA. We will assume that when they retire they will be in the 25% tax bracket. If they take a lump-sum distribution when they retire the lump-sum amount will push them into the 35% tax bracket. We will also assume they will get an 8% annualized return.
When Josh and Jenna retire, their IRA balance, Roth or Traditional, will be:
$264, 711 If they have a Traditional IRA and take out the entire lump sum, the amount, after taxes at the 35% rate is:
$172, 062. If they withdraw an equal amount of the proceeds over ten years, taxed at 25%, their annual withdrawal will be: $19, 853 per year.
Here is where the Roth IRA advantage becomes clear. If Josh and Jenna have a Roth, there are no taxes. They keep the ENTIRE $264, 711.
Tim and Trina Brown are 30 years old. They plan to retire at 70, so they have 40 years until retirement. They have 401(k) plans at their work and each employer matches 401(k) contributions up to 3%. They currently contribute $10,000 to their 401(k)s. Should Tim and Trina max out their 401(k) contributions? Or should they contribute to their 401(k)s only to the extent of the company match and put the rest into a Roth IRA? (The gentle readers should already know the answer, but here comes that math.)
If Tim and Trina continue putting $10,000 into their 401(k)s, they will have $296, 839, as a lump-sum (after tax) 401(k) withdrawal. If they take the proceeds over 10 years, they will get $34,251 per year.
However, if Tim and Trina limit their 401(k) contributions to only the company-matching amount, they will retire with $379,041. If they take it out over 10 years, they will get $38,817 per year. (These amounts include the taxes on the taxable 401(k) proceeds.)
$82, 202! That is the difference. 27% more than the 401(k) strategy. Put another way, 2.4 more years of income than the 401(k) strategy. A simple strategy that anyone can take advantage of.
The Author has an Excel Spreadsheet that calculates the relative advantages of the Roth/401(k) strategy. And if a 401(k) participant takes advantage of the company-match amount, and then reaches the Roth limit, he can still put more funds in his 401(k) up to his 401(k) limit.
The Author Has Just Shown You The Elephant[5]
The purpose of this newsletter is to dispense financial and investment advice, to help readers understand the investment and financial environment we face, and to entertain. Nothing the Author has said to date about Secular and Cyclical markets, interest rates, high price/earnings ratios, sector and market relative strength is as important as the foregoing discussion of the Roth IRA, the Traditional IRA, and the 401(k) max strategy. No investment strategy can even approach the wealth building effect that the proper deployment of these strategies can deliver. By using good tax avoidance strategies, you get a 25-35% return out of the gate.
Rumors of the Demise of the Federal Estate and Gift Tax Appear to be Somewhat Exaggerated (Well, just One Last Terrific Trope)
The Federal Estate and Gift Tax is scheduled to expire in 2010, but be reinstated in 2011. Seriously, this is what our elected representatives passed in 2002. (Imagine being an estate planner trying to address this bizarre situation.). Senate Majority Leader Bill Frist, heir to a huge healthcare fortune, had promised to bring up the repeal of the Estate and Gift Tax when Congress returned from its August recess. But in the wake of hurricane Katrina, he has stated he will delay consideration of repeal. Whether this delay is due to a glint of fiscal restraint in face of the staggering costs of rebuilding in Katrina’s wake and the crippling federal budget deficits, or a political move to appear less venal in the public eye, is difficult to determine. But the repeal measure will probably come up again. When the repeal of the Estate and Gift Tax comes up again, the Author will visit the issue. And he will drown its opponents in Grover Norquist’s bathtub.
Welcome to the Desert of the Real!
IMPORANT DISCLAIMER: This newsletter is offered for informational purposes only. Sources of information provided are believed to be reliable, but are not guaranteed to be complete or without error. Opinions and suggestions are provided with the understanding that readers acting on information contained herein assume all risks involved. The Author may or may not buy or sell securities discussed in this newsletter.
About the Author: The Author is a former corporate healthcare attorney, computer software company executive and stockbroker for a major wire house. He currently lives in Albuquerque, New Mexico. He trades for a living, works as a computer security consultant, and writes this newsletter to assist others in their investing activities and to keep abreast of important issues in the equity and financial markets.
He has a weblog where he writes on these topics. The link is:
http://desertoftherealecononomicanalysis.blogspot.com/
He may be reached by email at desertoftherealeconomics@hotmail.com.
[1] The title of this Newsletter, “Welcome to the Desert of the Real”, comes from the 1998 film “The Matrix”. The world in the Matrix is a Simulacrum, a computer–generated illusion. It only “looks” and “feels” like the late 20th century. Instead, human beings are enslaved in tanks of fluid, wired to the Matrix. Also, readers steeped in post-structuralist philosophy may recognize the title as a paraphrase of a quote in Jean Baudrilliard’s 1981 book, “Simulacra and Simulacrum”.
On the subject of films, the Guild Cinema is an art house movie theatre in Albuquerque. In September it screened a mockumentary entitled “Never Been Thawed”. Caustic and witty. The mockumentary is becoming a cinematic genre of its own. The first feature-length mockumentary the Author recalls is the 1983 send-up of rock bands, “Spinal Tap”. Spinal Tap still remains the benchmark, but the author believes that “Never Been Thawed” is funnier and more socially scathing.
Christopher Guest, who did Spinal Tap, has produced “Best in Show”, “Waiting for Guffman” and a “Mighty Wind”. And the Author has seen a couple other mockumentaries. A precursor of Spinal Tap was “The Ruttles”, a mockumentary by the Monty Python crew about for mop-topped rockers from Liverpool.
But perhaps the ultimate mockumentarians were two laboratory mice, one a genius, the other insane. “Pinky and the Brain” was one of the funniest and well-written cartoon series that the Author has ever seen. Some of the cartoons were parodies of famous movies, stage plays or television shows. Others were mockumentaries of social phenomena with the enduring subtext of Brain’s unchecked desire to “take over the world”. A particularly endearing character was Brain’s nemesis, an Orson Wellian hamster named Snowball. Narf! Zort!
[2] The misleading appellation for this tax adopted by estate and gift tax opponents “Death Tax” will not be dignified in this newsletter. As a still-licensed lawyer, the Author will refer to the tax by its proper citation. If he didn’t cite it properly, his Estate and Gift Tax professor, His Bloviateness, Lawrence Jegen, would hunt him down and grill him socratically for several hours.
[3] Tax deductions were more generous, however.
[4]A concern of Roth IRA holders is that the federal government may decide at some point in the future to tax Roth IRA withdrawals, limit the amount of Roth IRA withdrawals that are tax-exempt, or phase-out the exemption for high-income earners. This seems unlikely given the original promise of the Roth IRA that the proceeds be tax-free and the political power of retirees making Roth IRA withdrawals.
However, by non-direct means, the federal government has “raised” the taxes on traditional IRA withdrawals by compressing the tax brackets. And the trend toward tax bracket compression will probably continue under the pretense of “tax simplification”.
“Tax simplification” is a Washington canard, a glittering generality that has no meaning outside of a politician’s lexicon of trickery, or “Chumpery”. Chumpery (no relation to champerty) is when a politician addresses a hot-button issue with no intent (or real ability) to actually do anything about the issue. Prominent examples of Chumpery would include “Balanced Budget Amendment”, “Term Limits”, Flag Burning Amendment”, “Defense of Marriage Amendment”, or “Health Care Reform”. From the foregoing one could conclude that anytime a politician proposes something that would require a Constitutional amendment they are automatically engaging in Chumpery.
[5] “Seeing the Elephant” was a 19th century term for seeing or doing something unique or valuable. However, Civil War soldiers would also say that new men who first experienced combat had “seen the elephant.”
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