DEFERRED TAXATION SAVINGS

The U. S. government offers several different tax deferral schemes for workers to use to build their “nest egg.” There are 401K plans, individual retirement accounts (IRAs), Roth IRAs, self-employed pension (SEP) IRAs, and so on. Each of these plans serves a different purpose/customer base, and each has its own rules about taxation, contribution, withdrawal, and so on. Many books have been written on this topic, and I couldn’t possibly do it justice in a few pages. What I will do in the fol­lowing pages is to walk through a hypothetical saving for a retirement example and show the potential value of a tax-deferred savings plan. I will be using my online spreadsheet Ch9Taxation. xls.

Г ’ rl begin using the Nest Egg tab on the spreadsheet. You are 40 years old, planning to retire at age 65. Your income puts you well into the 25% tax bracket.

Table 9.3 Nest Egg Building Example

Input variables: Nr Mnthly Pmts = 300 Interest rate = 4.00% Mnthly Pmt = $250 Tax rate = 25%

Monthly contribution after withholding tax: $188

Pmt Nr

Month

Year

Taxed

savings

Tax – deferred savings

Balance

($)

Interest

($)

Tot Int/ Year ($)

Tax

($)

Balance

($)

Interest

($)

1

1

1

188

0

0

250

0

2

2

1

376

1

1

501

1

3

3

1

564

1

2

753

2

4

4

1

754

2

4

1,005

3

5

5

1

944

3

6

1,258

3

6

6

1

1,134

3

9

1,513

4

7

7

1

1,326

4

13

1,768

5

8

8

1

1,518

4

18

2,023

6

9

9

1

1,710

5

23

2,280

7

10

10

1

1,903

6

28

2,538

8

11

11

1

2,097

6

35

2,796

8

12

12

1

2,281

7

42

10

3,056

9

13

1

2

2,476

8

8

3,316

10

14

2

2

2,672

8

16

3,577

11

15

3

2

2,869

9

25

3,839

12

296

8

25

82,737

274

2,151

125,841

417

297

9

25

83,201

276

2,427

126,511

419

298

10

25

83,666

277

2,704

127,182

422

299

11

25

84,132

279

2,983

127,856

424

300

12

25

83,784

280

3,264

816

128,532

426

You want to divert $250 of your gross salary each month to an account that will give you 4% interest annual percentage rate (APR). This example is shown in Table 9.3 .

The first thing that happens is that some money is withheld from your paycheck for taxes. To keep things simple, I’ll assume that the exact tax payment is deducted each month. I’m ignoring social security, Medicare, state tax, and any other deduc­tions. The money you have available to contribute is 75% of $250 = $188 (cell K1 on the spreadsheet). The spreadsheet shows the balance growth each month and the interest paid into the account each month. At the end of the year, tax is paid on the year’s interest, and this amount is deducted from the balance.1

At the end of 25 years (300 monthly payments), your balance, after taxes, is $83,784.

Look at the tax-deferred savings columns. Assuming your plan deposits pay­ments pretax (some, but not all of them do), the full $250 goes into the account every month. The interest accrued does not get taxed, and at the end of the 25-year period, the balance in the account is $128,532.

The tax-deferred plan has about 50% more in it than the simple savings plan. Remember, however, that the simple savings plan money is all yours at this

Table 9.4 Retirement Phase of Nest Egg Building Example

Input variables: Monthly withdrawal = Tax rate = 10% Interest rate = 4.00%

$750

Taxed

savings

Tax – deferred

savings

Month

Balance Interest

Tax

Month

Balance

Interest

Tax

($)

($)

($)

($)

($)

($)

1

83,382

278

28

1

127,782

426

75

2

82,882

276

28

2

127,383

425

75

3

82,381

275

27

3

126,983

423

75

4

81,878

273

27

4

126,581

422

75

5

81,374

271

27

5

126,178

421

75

6

80,868

270

27

6

125,774

419

75

7

80,360

268

27

7

125,368

418

75

8

79,851

266

27

8

124,961

417

75

9

79,341

264

26

9

124,552

415

75

134

1,832

6

1

134

61,130

204

75

135

1,087

4

0

135

60,509

202

75

136

341

1

0

136

59,886

200

75

137

-408

– 1

0

137

59,260

198

75

138

58,633

195

75

139

58,003

193

75

217

1,842

6

75

218

1,024

3

75

219

202

1

75

220

– 622

-2

75

1 If I were doing present value calculations, I’d note that the tax on the year’s interest doesn’t get paid until the following April. For these examples, I’m keeping things simple by just deducting the tax payment from the balance at the end of the year.

point—it’s all after-tax money. The money in the deferred tax plan is still yet to be paid.

Now look at the Retirement tab of Ch9Taxation. xls (shown in Table 9.4). I’ve simplified the calculations in that I show the tax generated each month being paid that month. Let’s say you would like to draw $750 each month from your account. Since you’re retired, you’re probably in a lower tax bracket than you were when you were working. I’ll use 10% for the example. I left the interest rate at 4%; this of course could have changed over the years.

In the case of the taxed savings account, the tax is the tax rate multiplied by the interest earned (each month). For this tax-deferred plan, you pay taxes on the money as you withdraw it. The taxed savings monthly tax starts off lower than the tax-deferred savings monthly tax and gets a little lower every month. The higher initial balance in the tax-deferred savings account outweighs this tax disadvantage, however: The taxed savings account runs out of money in about ІШ years, while the tax-deferred account lasts about 18^ years. This is significantly a better retirement funding.

A word of warning: Each government – approved plan has its own rules about taxing contributions and taxing disbursements. There are also rules about withdrawing money from the account while still in the “nest egg” phase, as well as rules about maximum contributions, and rules about everything else (there are probably rules about writing rules). To make it worse, these rules keep changing. Do your homework.

In good times, many employers will match employees’ contributions to retire­ment funds up to some maximum percentage specified by the IRS. This is an effec­tive pay raise. If you find yourself in this fortunate situation, increase the nest egg contribution amount in the spreadsheet by your employer’s contribution to see how your balance will grow. Keep in mind that this contribution only applies to the tax – deferred savings numbers; there is no matching contribution for a personal savings account.

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