Pension Plan vs. Taxable Account

[goldtpa]

I am having a debate with a friend who is a CPA. He is now thinking about telling his client to forget about his DB plan and put the money away in a taxable account; due to the new 15% tax. Here is the scoop

48 year old Dr. looking to retire at 60. Contribution to a DB plan approx 100,000. Makes well over 200,000 in comp.

Assuming the Dr takes the 100,000 he would have contributed to the DB. He pays 40% in tax and invests the 60,000 into an investment making 5%. In 13 years paying 22% in taxes (15% fed and 7% NY State) he would have approx 991,000.

The CPAs argument is that the lump sum payment from the DB is not that much larger than the amount in the taxable account. His thought is that is goes against everything we have been taught to believe, which is you'll make more moeny in the retirement account than paying taxes each year. According to him the difference between the two is not a slam dunk as you would think it would be.

I know that a few other CPAs I have talked to have been to seminars on this topic. Any thoughts?

[Mike Preston]

His numbers seem correct if you are going to mandate a lump sum at the end of the 13th year and if you are going to assume the 15% rate applies uniformly and you are going to mandate a lump sum, and pay tax on the full amount, at the end of the 13th year. Most of the time, though, the qualified plan's $1,771,298 would be rolled to an IRA and contiinue to enjoy shelter from current tax. Further, when dribbled out of the IRA, the effective tax rate might be less than the presumed 40%.

In general, the CPA is correct, though: the 15% tax rate is definitely a disincentive to the retirement system.

[Blinky the 3-eyed Fish]

I could be misinformed, but my understanding is that the capital gains rate is the lowest since 1911. I think a more appropriate analysis would be to factor in an average capital gains rate over the last x years, because that 15% is much more likely to go up and is unlikely to go down.

[mwyatt]

Mike is onto something with the effective tax rate on the IRA withdrawals. You figure that everything currently taken off the top of income is being taxed at the highest marginal rate, while ultimately when you start drawing down on your IRA to provide your income in retirement, the effective taxation rate will probably be much lower.

These tax questions are intriguing though; just this morning a CPA wanted to what the impact would be of increasing the owner's wife's salary (2 person plan) to get a higher PS contribution for her. I figured out that the PS contribution would be in the 17-18% range, after taking into account the DB deposit. However, since extra funds to pay for her salary would be subject to FICA (effectively 15.3% since she was well under the TWB), didn't seem very cost-effective to shore up SS for an additional PS deposit of roughly the same amount (I brought this point up, not the CPA, BTW).

I guess the moral is that sometimes we all have to look out of our little corner of the world and think things through to their logical end. Of course, one should remember the old CPA adage of never pay a tax today that you can pay later. I'm glad for some of my old pre-TRA '86 grossly overfunded DB clients that we kept things going in time for the EGTRRA increases instead of pulling the plug earlier (of course, three years of slaughter in the markets didn't hurt either...)

[AndyH]

Just a side note on CPAs and DB plans. I have known very few that are not terrified of DB plans. And fewer that understand FAS87.

[mwyatt]

But nothing spells disaster better than brokers and DB plans. Just had one who wanted to me to run a proposal for a new DB plan for an over 100 life company with 4 owners in their early to mid 40s, with a result of getting more than half of the contribution to the owners. Not wanting to spend 15 hours scrubbing data to prove that this was a collosal waste of my (unbillable in his eyes) time, tried to dissuade him that his buddy's case (much smaller census with much older owners) might have had a little more favorable census base to play with... We'll see if he can actually understand what a DB plan is the next time and when it will work (I shudder about someone trying to pitch over 100 life cases as "tax shelters").

[david rigby]

I think the original analysis ignored an important point. What makes up that marginal 40%? Did it include the SS tax? Perhaps it is only 1.45% (or 2.90%) but don't overlook it. Remember that a qualified PS or DB plan [but not 401(k)] is a great way to permanently shelter money from SS tax.

[mwyatt]

Point well taken Pax, but most of the heavy hitters are well beyond the TWB, so the comparison is with 2.9%, not 15.3%. However, one critical point is that pension contributions (I believe) lower your AGI BEFORE the Alternate Minimum Tax, which may even be a bigger point...

[mbozek]

I think the CPA adage of not paying a tax today that can be paid later is not good advice for persons who are eligible for Roth accounts. Under current tax law a married couple with $72,400 in income will be in the 15% tax bracket. A Roth IRA contribution of $3,000 for each spouse would require the payment of $900 in fed tax. After 10 years at 6% interest the account would be worth $10,745 with no income tax due. If the same amounts are contributed to a 401(k) plan for 10 years at 6%, the $10,745 would be be subject to $1611 in taxes (@$15%) leaving the accounts with a net value of $9134. The viability of pre tax deferral will move to center stage in 2006 when Roth 401(k) and 403(b) plans will be available for participants.

[Mike Preston]

mbozek, I hate to rain on your parade, but the analysis you present is seriously flawed. One of the hallmarks of taxation (and Roth IRA's) is that if the tax rate stays the same at all points in time, there is no difference between a Roth IRA and a regular IRA. Or, in this case, a Roth and a 401(k).

In your example, in order to pay the $900 tax, your couple must have income of some amount, which when taxed, will allow them to write that $900 check to the IRS. That amount is $1,058.82. When added to the original $6,000 and accumulated for 10 years gives you $12,641.27. Which, if you pull it all out at that time and pay 15% tax, you are left with $10,745.

What you are saying though is absolutely true about 2006. People who have an interest in seeing one form of retirement savings succeed over another form will concoct examples that favor their pet method. And most people can be easily fooled into accepting such an analysis. I mean, if it can happen to you (I presume you picked up this "example" from somehwere else), someone is obviously much more familiar with retirement concepts, taxation and compound interest, it can happen to almost anybody.

[Blinky the 3-eyed Fish]

Mike, I was confused by your example, so let me present mine and I will let you point out the flaws.

Roth IRA

72,400 income - 10,860 taxes = 61,540

Let's just say they spend 55,540 and put the 6,000 into a Roth

6,000 after 10 years at 6% grows to 10,745

Regular IRA

72,400 income - 6,000 IRA contribution leaves 66,400

66,400 - 9,960 taxes = 56,440

Again they spend 55,540 leaving 900 remaining

10,745 after 10 years is taxable leaving 9,133 left

The 900 they had saved is invested and is 1,612 after 10 yrs and is also taxable leaving 1,370

Total 10,503, which means they are 242 worse off than with the Roth or the difference in taxes in the money invested outside of either plan.

Mike, as I work through the example, I see now that your numbers are correct only if the excess money can be invested in the regular IRA

72,400 - 7,058.82 IRA contribution (assuming the limits went up) leaves 65,341

65,341 - 9,801 = 55,540

7058.82 at 6% for 10 years is 12,641.27 (same number)

12,641.27 - 1,896.19 = 10,745

[Mike Preston]

mbozek's example was comparing a Roth IRA to a 401(k), not to a regular IRA. I agree with you that if there are ceilings as to contribution amounts, they can distort the economic impact. In the case of a Roth IRA versus a Regular IRA, for example, is it appropriate to first compare the amount that would not be affected by a ceiling and then do an analysis on the balance? Probably, but you would lose most people in the general population by doing so.

[Lame Duck]

Blinky,

I'm not an accountant or an actuary so I might be looking at this wrong, but I think you made one error in your calculation on the taxes payable for the $900 investment. Since the $900 is an after tax investment, it would not be taxed again when it is removed. Asuuming the investment was made in some kind of tax deferred vehicle, you would be taxed on gains of $712. After taxes at 15%, you would be left with $605 plus the original $900, for a total amount of $1,505. When added to the traditional IRA distribution (after tax) of $9,133, you have a total net value of $10,638. This is still $107 less than the net value of the Roth IRA. The result would be different if the $900 was in vested in a taxable account and the gains were taxed every year, but that calculation is a little more than my tired brain can puzzle through at the moment.

[Blinky the 3-eyed Fish]

Yeah, you and Mike are both right.