Everything You Know About Taxing Retirement Saving Is WRONG!

Republicans have discussed eliminating pre-tax contributions to 401(k) plans as part of their massive tax overhaul.  Everything you've read says this is a terrible result for you.  But everything you've read is wrong.  Here are five reasons...I cannot believe I am writing this...I agree with the GOP thought exercise that will never become reality...

Reason #1: Pre-tax savings forces difficult mental accounting, and allows you to delude yourself.. 

Deep down, you know this.  The taxes are due at some point.  How can you correctly plan for retirement when you are looking at total balances instead of after-tax distributions from that balance?  This make a difficult long term planning problem worse.  Tell me, what is your marginal tax rate going to be in 2040?

Reason #2: Pre-tax savings makes it easier for Congress to screw you in the future.

Are you really confident that your tax rate today is higher than your tax rate 20, 30 or 50 years from now?  Congress can more easily raise taxes on income they have not yet taxed than income already taxed.  This is why wealthy people are such fans of Roth conversions of their IRAs and 401(k)s.

Have you factored in inflation?  What if inflation moves up in the next 40 years, and your real value of assets in that 401(k) haven't moved, but your distributions are way higher in nominal terms?  Think that's crazy? Forty years of 6% inflation means you have 10x the dollars, but they buy you the same stuff.  Think I'm crazy?  A lot can happen in 40 years.

Reason #3: Deferring taxes benefits those finance folks you love to hate.

So, if you only really get $65,000 of future value from that $100,000 balance, who wins?  Not the government, until they raise the future rate (reason #2...and they will do it!)  Your mutual fund manager!  She wins big.  She collects management fees on the extra $35,000 that you give to her instead of the government.  She's thrilled.  You and your colleagues at work just built the new kitchen for her summer home.

Reason #4: Deferring taxes raises your tax rates.

This one is for the advanced reader.  If you hold an equity index fund, the vast majority of your gains are capital gains, and they are deferred as long as you hold the investment.  This is true of individual stocks as well.  So, you basically don't pay taxes until you sell the investment, and then at reduced rates because it's a capital gain.  On the flip side, when you hold long term equity assets in your 401(k), you are converting what would otherwise be capital gains into future ordinary income.

If you do some pretty simple calculations, you can show that owning equity index funds in a retirement plan actually destroys value versus holding the same investment in a taxable plan.  You are holding assets that defer taxes forever at capital gains rates, but you then put them into a vehicle that makes them into ordinary income, taxed at an unknown, higher, future rate.

[Pro tip: Very wealthy people don't hold equities in retirement plans.  They hold investments that generate ordinary income in retirement plans, and hold stocks in taxable accounts.]

Reason #5: Deferring taxes benefits the finance folks you don't like...even more!!

This one is for the even more advanced reader.  So, you have your pre-tax 401(k) account.  What to do with it?  You look for a "good" portfolio manager, whatever that means to you.  I can tell you if you aren't a professional, you are probably wrong in this decision.  If you are a professional, you know your chances of being right are only slightly better than your changes of being wrong.  If you're truly an expert, than you know a 401(k) can't be invested the way you want to invest.

You don't given a damn if your portfolio manager changes stocks like he changes socks.  You aren't taxed on gains, and you don't distinguish between short term and long term.  So, you have an incentive to seek out a manager who does "something" to add value over that passive index.  That "doing something" costs you real money in higher fees over the long term, and maybe it adds value.  (see reason #4 again...)  And it keeps your fancy portfolio manager employed.  Now, she's thanking you for the whole summer house, not just the new kitchen.

#EndingTBTF

The Federal Reserve Bank of Minneapolis seeks comments on how to end "Too Big To Fail".

A friend suggested I submit something, so maybe I'd be heard.  So, here goes.  I am simply submitting a link to this blog post:

I've written before how to do this conceptually, but here I'm giving slightly more detail:

Banks engage in two unrelated businesses:

• Banks make loans;
• Banks accept demand deposits.

We only think these activities are related because that's how banks have always worked.

TBTF status arises because banks currently face a mismatch between demand deposits and loans.  You can't call all the loans to return cash to depositors.  FDIC works for small, idiosyncratic risks of bank failures.  Not giant or systematic ones.  If we separate those activities, we shall see that the companies that accept demand deposits cannot fail and the companies that engage in lending fail to the detriment of their risk taking investors, not the public.

Three simple steps separate these activities:

First, Allow anyone to own a bank with 100% reserves.

Regulations today put severe restrictions on who can own banks.  For the most part, non-financial companies cannot own banks.  Regulators worried that bank deposits might end up supporting non-bank operations.  Additionally, lending to competitors of the non-bank company might lead to anti-competitive behavior.  (Imagine you made a loan to your competitor widget producer, and threatened to call the loan if they lowered their prices below yours.) 

Now suppose you had a special class of bank that did not make loans.  This bank held physical currency, Treasury securities and reserves as the Fed.  This bank only deals in demand deposits and riskless securities.  This bank cannot lend to companies or people.  This bank cannot have a run.

This bank is not very profitable.  This bank makes money on the spread between interest paid on reserves, Treasury securities and transaction fees.  It might pay interest, depending on expenses.  Who engages in this seemingly capital intensive, not very profitable business?  Walmart, Target, Home Depot, Costco immediately start banks.  They have stores full of tellers and cash.  Currency is simply a product they already carry in their stores.


Second, Modify FDIC pricing

 FDIC protects bank customers from bank runs.  Because it protects bank customers, it protects bank shareholders.  FDIC (and the risk of exceeding FDIC limits) are the source of TBTF.  Bank customers treat bank deposits as riskless because they've been trained by FDIC to believe it.  Corporate (and very wealthy) customers with deposits exceeding limits do not have a riskless alternative EXCEPT TBTF.  If my company's payroll is $100 million a month, where do I put that cash so that it is absolutely safe?

New FDIC rules say banks with 100% reserves do not have to pay for FDIC insurance.  Note: I'm not saying (right away) eliminate it.  That would not be perceived well by the public.  But, it's free.  Because FDIC has no risk.

(Eventually, FDIC goes away.  Or, maybe, since FDIC is much smaller than the industry of banking oversight in general, FDIC becomes the official organization that looks at a bank's balance sheet for about 10 minutes a quarter to say: Yup, you have no loans, and your cash plus Treasury securities plus reserves at the Fed equals your deposits.  You're good to go!)

At the same time, ramp up FDIC insurance pricing quickly to banks with less than 100% reserves.  Price increases will control the speed with which we separate demand deposit management from lending.  FDIC transitions from an insurance handout encouraging TBTF to a painful tax on commingling demand deposits and lending.

What happens to the existing banks?  They restructure into a banking subsidiary managing deposits and an investment manager running mutual funds, (because in the next step we kill money market funds!)


Third, eliminate money market fund pricing exemptions

Money market funds exist to deceive the public.  I'm not overstating this in any way.  If we remove the exemptions that allow money market funds to manipulate their net asset values so they look riskless, then the public will understand that bank deposits (in a 100% reserve bank) have no risk, but that money market fund's share price bounces around a little because it is risky.  The money market fund is pretty darn available for withdrawal, but the price moves.

Under these circumstances, the saving and investing public makes clear distinctions between storing money in a way that is always available (saving), and lending money for risk taking purposes (investing.)

I suspect this third step would be the end of money market funds.  Money market funds would become ultra short term bond funds...because that's what they are without the regulations designed to deceive us.  At that point, however, there would be no reason NOT to let them fail.  You, the investor took a risk.  Too bad.  You had an alternative.

Malcolm Forgot Who Stands In The Middle: Why American Taxpayers Don't Cheat

Malcolm Galdwell hit the Sunday TV circuit this week in preparation for dreaded Tax Day.  In this video from CNN, he reiterates his standard trope about legitimacy.  He tells us that cheating on our income taxes carries little risk because the IRS audits so few, and the penalties lack teeth.  But, we pay anyway because we think the system is legitimate.

Gladwell needs to read some economics.  Seriously.  Tirole.  Milgrom.  Holstrom.  Something on principal agent problems?!?  Unless you follow the Wesley Snipes strategy and just don't pay, (which lands you in jail,) cheating on your taxes is pretty darn hard.

The United States taxpayer faces a uniquely complex, arcane and ridiculous system.  Gladwell has that one right.  Knowing little about the (vast number of) readers of this blog, I suspect only my mother prepares her taxes unassisted by anything more than IRS instruction documents and a sharp pencil.  No software.  No accountant.

Even minor complications cause the average American to toss her hands up and hire a professional.  Given the vast sums spent advertising by low cost tax prep companies, I'd imagine the vast majority of even "simple" returns have professional help.

(Yes, refund anticipation loans may drive the profits of these shops, but that tells us people have decided that the value of the loan is worth more than the expected value of their ability to cheat successfully.)

So, why is Gladwell delusional?  He ignores the principal-agent problem the tax code manufactures.  We Americans cannot file our own taxes.  Therefore, we cannot cheat without a colluding professional.  That professional's entire career depends on a working relationship with the IRS.  Your tax gal will not let you cheat.  She monitors you, on behalf of the IRS.  And, for this you willingly pay her!

An early Happy April 15!

Sam Peltzman on World Cup Skiing

That's Bode Miller last week in Beaver Creek, CO, not me.  Looks like he could use an airbag.  The thing is, skiing airbags exist, but no one will wear one.

In this New York Times story, Marco Sullivan, U.S. Olympic skier notes "If you're the only guy wearing it, it's probably a disadvantage as far as speed goes."  In fact, the author notes less than a second separated gold from 12th place.  Six one-hundredths of a second separated gold from silver.

Sam Peltzman earned his fame demonstrating that seat belts made drivers faster and more reckless. They compensate for their increased safety.

I am far from a skiing expert, but I have to imagine that the marginally faster/more reckless skiing due to wearing the airbag more than makes up for the weight differential, and just might make up for that 0.06 seconds for second place.

The Ultimate Short Volatility Trade

My mother-in-law has a magic nose.  She diagnosed a gas leak in our main feed into the house in 2009 that the "electronic nose" the PSE&G guy carries took an hour to find.  So, when she arrived tonight and announced she smelled gas, I called the emergency hotline.