401(k) RULE CHANGE

The baby boomers have been sold a massive bill of goods. This started back in grammar school and continued right through college. This myth was based upon certain principles that were geared to reward conformity and ultimately punish any pursuit outside the realm of the status quo. While this indoctrination was not transparent or even evident, it has clearly surfaced today and is being unashamedly enacted upon the coming youth.

The principles of financial conformity are as follows:



Tax deferral is always best. (This was a big lie.)
Maxing out qualified retirement plans is your best move. (This was a white lie.)
Diversifying your portfolio with mutual funds is wise. (This was a fee grab lie.)
Keeping your money in the market is always best. (This was a commission grab lie.)
Use leverage with low interest rates. (This was a banking manipulation lie.)
Karl Schilling

L M R N O V E M B E R 2 0 1 3
A Framework for Tax Timing

by
Robert P. Murphy

 

Important decisions about financial planning often revolve around the tax consequences
U.S. tax code, certain assets are taxed “upfront,” while other assets grow on a tax-deferred basis.
This can often make it confusing to think through the full ramifications of selling down one asset in order to build up another, because the move changes the timing of taxation.
In this article, I want to give the reader a framework for evaluating the timing of taxation. I am not,in this article, providing financial  recommendations, or pushing one asset class versus another. I merely want to walk through the ramifications of various courses of action, so that the reader can make an informed decision when considering such moves.


Current regulations and guidelines regarding the sale of tax qualified investments


Many readers of the LMR are financial professionals, and I want to be sure such readers understand the current rules: Only individuals with the proper securities licenses are permitted to counsel holdings in order to buy real estate or physical gold “is situation is awkward, but it is the situation.
For example, suppose there is a life insurance agent who thinks the stock market is in a bubble, and has personally cashed out his tax qualified plan in order to fund a large whole life insurance policy taken out on himself.

Important decisions about financial planning often revolve around the tax consequences. With the current configuration of the U.S. tax code, certain assets are taxed “upfront,” while other assets grow on a tax-deferred basis. “is can often make it confusing to think through the full ramifications of selling down one asset in order to build up another, because the move changes the timing of taxation.

In this article, I want to give the reader a framework for evaluating the timing of taxation.
I am not, in this article, providing financial recommendations, or pushing one asset class versus another. I merely want to walk through the ramifications of various courses of action, so that the reader can make an informed decision when considering such moves.

Many readers of the LMR are financial professionals, and I want to be sure such readers understand the current rules: Only individuals with the proper securities licenses are permitted to counsel clients on, say, selling off 401(k) holdings in order to buy real estate or physical gold.

This situation is awkward, but it is the situation. For example, suppose there is a life insurance agent who thinks the stock market is in a bubble, and has personally cashed out his tax-qualified plan in order to fund a large, whole life insurance policy taken out on himself. If this agent has a license to sell life insurance, but neither holds a securities license nor is a Certified Financial Planner, then strictly speaking, even if his best friend comes to him and asks for help in “doing what you did” with his finances, the life insurance agent can’t comply with the request.


Officially, he is not supposed to be “facilitating” the sale of a client’s securities, because he is not properly licensed to do so.
Because of this awkward but nonetheless real situation, individuals must discuss their overall financial plans with others who are not involved directly with the particular transactions.
If Joe Smith wants to cash out his 401(k) and use the proceeds to fund a large life insurance policy, when he talks to a life insurance agent (who doesn’t have a securities license) Joe Smith needs to confine the discussion to how much he is willing to pay in premiums. He shouldn’t be bringing up the fact that he reduced his 401(k) to get the money, because this then puts the life insurance agent in an untenable position, where he’s not allowed to tell Joe Smith what he thinks the best course of action is—even if he’s only telling Joe Smith exactly what he himself is doing with his own finances!
In light of the  regulatory environment (absurd though it may be), it’s crucial that individuals know how to think through financial decisions on their own. “The present article is offered to that end.


A hypothetical Case Study


In order to walk through our framework, it will help to have a concrete example in mind. Suppose Joe SMith is 65, and has $600,000 in a 401(k). His house is paid for, and he has modest expenses. He draws out $40,000 per year from his plan to live on. (naturally, he pays income tax on that money as he pulls it out.) The investments roll over at a perpetual 5%. Joe figures he can draw down the 401(k) in this fashion for 25 years, getting him to age 90.

Joe is now considering whether it makes sense to move some or all of his wealth out of the401(k), and transfer it to a different asset that is not tax qualified. If there were no tax considerations, we can suppose Joe would make the transfer without delay, because he prefers the new asset for some reason. But he realizes there will be an upfront tax hit from his move, and he wants to think through the full ramifications.


In the rest of this article, we will walk through some basic considerations. We’ll start very simple, only looking at a few factors, and then we’ll progressively make the analysis more realistic by adding more complications. We’ll start very simple, only looking at a few factors, and then we’ll progressively make the analysis more realistic by adding more complications.

Simplest Case: equivalent Asset, no Penalty, Flat income Tax Code

Let’s start with some very unrealistic assumptions just to get warmed up. Suppose Joe is transferring his wealth to an equivalent asset, which will have the identical risk and return as the original. Further assume there’s no penalty for withdrawal. He does have to pay the income tax, of course, but the flat tax code has a single 10% rate for all levels of income, with no deductions.


In the original baseline scenario, Joe takes out $40,000 from his 401(k) every year. He pays tax of 10% which is $4,000, meaning he has $36,000 after-tax on which to live.

In the new scenario, Joe takes out the full $600,000 in one fell swoop. He pays the 10% in taxes, which is $60,000. This of course is quite painful; Joe feels physically ill writing such a check to the IRS.Then he puts the remaining $540,000 in an asset that earns a perpetual 5 % return.

Starting out with 10% less principal, obviously Joe will run out of money earlier, if he draws down at the same rate as before. But now, Joe can withdraw his money and not pay additional tax. (That’s the structure of our story here.) In order to maintain his lifestyle, that means Joe only has to draw out $36,000 per year, because that was his after-tax income in the original, baseline scenario.

Starting out with $540,000 which rolls over at 5% annually, Joe can draw out $36,000 and once again go for a full 25 years – the same outcome as in the baseline scenario with the 401(k).

Thus, at the most basic level of analysis, the tax consequences are a complete wash: By emptying his 401(k) and moving it into an asset where the tax occurs completely on the front end, Joe didn’t affect his lifetime tax liability (measured in present value terms). He simply paid the tax upfront, rather than spreading it out over 25 years. The amount of income available for him to actually spend each year is identical in both scenarios.


Before moving on, I should clarify: When I say that tax liability is the same in both cases, I am referring to the present discounted value of the total lifetime tax payments, measured at the start. In contrast, if we look at the actual total dollar payments, then obviously Joe pays more in the 401(k) scenario. There, he pays $4,000 per year, for 25 years, working out to total payments of $100,000.

In contrast, if Joe moves the entire $600,000 to the new asset, he pays a one-time tax bite of $60,000. Since $60,000 is less than $100,000, there’s a sense in which Joe “pays less to the IRS” by switching assets. However, this type of statement isn’t really economically meaningful, because dollars paid today to the IRS are worth more than dollars that won’t fall due until years from now.

Here’s another way to illustrate the tax equivalence: With the lump sum $60,000 that Joe has earmarked to pay the IRS he could instead send them $4,000 per year, with the balance rolling over at 5%. With this approach, the principal would once again last 25 years, during which time Joe would pay out a total of $100,000 rather than the initial $60,000. But paying the $100,000 wouldn’t “cost” Joe more than the initial $60,000, obviously, since he would just keep the balance rolling over without having to kick in any extra money.


Complications That make the move Less Attractive


In the previous section, we saw the most basic result: With enough simplifying assumptions, the raw consequences of the timing of the tax wash out. It doesn’t matter to Joe whether he pays the total tax upfront and gets it over with, or whether he draws it out over the rest of his life. By keeping his money in the 401(k) and deferring the tax, there’s a higher principal rolling over and thus he “earns more in total income,” it’s true, but that surplus is exactly how much higher his tax bill will be when he actually pays it. The whole thing is a wash.

In this section, we’ll brie%y discuss some of the real-world complications that make the move less attractive than keeping the money in the 401(k). Naturally, none of these issues, by itself is decisive, but in the real world Joe will need to consider them before making his final decision.

First, there is the fact that income taxes are not %at. With a graduated income tax code, the marginal rate of tax is higher, the higher the absolute level of income. In our example, suppose that the 10% bracket extends only to $100,000, and that all income above that is taxed at 20%. In this case, when Joe takes out the full $600,000, he would pay a total tax of (10% x $100,000 + 20% x $500,000) = $110,000. This is a full $50,000 more than what we calculated in the previous section; the extra bite is coming from the extra 10 percent points of income tax levied against the $500,000 falling into the upper income bracket. If we have already extablished that an initial tax bite of $60,000 is roughly equivalent to leaving the money in the    401(k) and paying $4,000 annually in taxes, then clearly if Joe has to pay $110,000 upfront, he is paying more in taxes because of the graduated tax code – a full $50,000 more, to be precise.

Naturally, one obvious way for Joe to compromise in this setting would be to gradually transfer the money out, $100,000 per year, so that he never puts himself into the higher tax bracket. By the seventh year, Joe will have moved the money completely and once again (ignoring the other complications we have yet to consider) the tax consequences would be a complete wash.

Another, related complication is that there could be an outright penalty (in addition to the standard tax) associated with Joe’s large withdrawals from his 401(k).Here to depending on the specific numbers, Joe might be able to minimize the blow by spreading out the draw-down over a period of years.

Finally, another complication making the move less attractive is the possibility that the government will change the tax code, so that Joe’s new asset is subject to tax on its growth. In this case, Joe would be getting hit with a double whammy: He writes a huge check to the IRS when he initially withdraws the money from his 401(k), but then over the years he continues to accrue additional tax liability as his (new) investments earn a return. Joe might be tempted to complain that this change in the rules wasn’t fair, but that’s never stopped the government before.

Complications That make the move more Attractive

Now let’s consider some complications that make the asset move more attractive. First, there is the very likely possibility that marginal income tax rates will be higher down the road.
Currently the U.S. federal income tax code has historically low rates, and the precarious debt situation (including Social Security and Medicare obligations) makes “tax hikes on the rich” a very real concern. If marginal income tax rates will be higher in 20 years, it makes sense for Joe to pay his taxes today, at the lower rates.


Another consideration is that the government could change the tax rules governing Joe’s 401(k). Indeed, in this month’s “Pulse on the Market” section, we explain that the Obama Administration’s proposed budget for 2014 suggests capping the amount someone can place in currently tax qualified plans. Depending on how bad the government’s fiscal crunch becomes, the nation’s 401(k)s and other such assets might prove an irresistible target for ravenous politicians.

Finally, there is the hard-to-quantify benefit to Joe of taking his money out of the micromanaged, government-approved environment and placing it somewhere with more privacy and freedom. Many people view money invested in 401(k)s and similar vehicles as “sitting in prison.”

Conclusion

“This article presented a very basic framework to analyze the timing of tax consequences related to shifts in asset holdings. Naturally we only touched on some of the biggest considerations, while ignoring many others. “The point of the article is not to push readers into specific moves, but rather to show the proper way to think about them.
In the simplest analysis, changing the timing of tax liabilities is a complete wash; the individual is paying “the same” lifetime tax, either upfront in lump sum or drawn out over decades.
In the real world, there are complicating factors that alter this simplistic result: Some factors push one way, some factors push the other. The individual or household must weigh these (and other) complications and decide what their net effect is, and how they change the baseline result of perfect tax equivalence.


Share

December 4, 2013 · Jennifer · No Comments
Tags: , ,  · Posted in: 401k Rule Change

Leave a Reply