Sunday, October 29, 2017

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.