Disadvantage of ADP Refunds

[austin3515]

Has anyone ever seen an analysis done for just how detriminental ADP refunds are to an HCE's savings IF the refunds are invested after tax in a regular brokerage account?  I wonder if there is even analysis that suggests if you pay all the withholding out of other assets and invest the proceeds.

I'm asking because I have been lately telling people that if you invest the refund instead of spending it, you are probably not so terribly worse off. Would love to have some economic analysis to back me up on this.

I am of course not suggesting that investing after-tax is better, only that the disadvantage is not drastic (but who knows, maybe it is?).  Would love to see the numbers!

[TPAJake]

Check out Betterment, they actually have a tool that coordinates your pre-tax Employer Plan & your after-tax investment account (such as you would fund with said ADP refund) to actively "harvest" losses & reduce taxes between the 2 accounts.  They might have something very close to the research you're after

[austin3515]

I found the website.  Is there a link to the tool you are referring to?  Or is it a software you have to buy?

[Belgarath]

"Economic Analysis" - reminds me of a line in "Pretty Woman" where Richard Gere asks Julia Roberts what her name is. Her answer was, "What do you want it to be?"

Seems like economic analysis usually has the same approach to an answer - "What do you want it to be?"

This is obviously somewhat tongue in cheek, but by no means entirely in jest.

[austin3515]

Well, but would you agree that because a) LT capital gains are not much; b) you're 401k will be taxed as an ordinariy income when withdrawn, that the difference probably is not as significant as you might expect?  And that probably goes double if you can pay the taxes out of "excess" cash flow (as you might for example replace an oil burner in your home if it went belly up).

I've had people reduced to tears over a $5,000 refund, and I want to say, hold on, this is not so bad - if you invest the refund you're not so bad off as you think...

[TPAJake]

https://www.betterment.com/resources/research/tax-loss-harvesting-white-paper/

Hopefully its ok to post links to these sites, otherwise my apologies...  I don't know that you have to buy anything, but you would need to have an account there to actually use the service.  If you understand the concepts involved & are willing to put in the time, any investor could accomplish the same thing manually

[Belgarath]

I neither agree nor disagree. There is such a universe of facts and circumstances that could affect the final outcome that I wouldn't dare to generalize. (How's that for a non-answer?)

[shERPA]

I've done some work in comparing pre-tax and post-tax savings on retirement income.  The math is straightforward, the devil is in the assumptions, but the effect is dramatic.

Assume a 50 yr old HCE can defer only $14K instead of $24K due to the ADP limit.  Assume 6% net of expense investment return, 50%/35% combined pre/post-retirement tax rates.   Ignore attributable match, the ACA 3.8% investment tax, any cap gains tax rate or timing preferences.  Assume equal investment expenses either in or out of the plan.

$10K for 15 yrs grows to $232,760 at 65.  This may be withdrawn @ $18,208 for 25 years, pay income tax each year on the withdrawal and you're left with $11,835 cash flow.

If the $10K is refunded or not deferred each year, $5K is available to invest and the earnings are taxed each year.  This will grow to $92,995 at 65.  Withdraw $5,890 per year for 25 years.  No further tax to pay as it is after-tax savings, so $5,890 of cash flow.

The ADP limit costs this participant $5,945 per year in retirement cash flow from age 65-90.

Even if you make the pre/post tax rates the same, say 50%, the pre-tax savings produces over $3,200 net after-tax cash flow.

[austin3515]

Wow.  They've gotta fix this stupid test.  People making $130K do not have the resources to make up for that sort of deficit.  That is insane.

I will say that the 50% rate is probably too high for the lower paid HCE's.  And someone in a bracket high enough to pay 50% taxes is probably going to be just fine.

I have also dabbled in spreadsheets like what you have done, but I just am surprised that there is not a website that compares and contrasts pre-tax/post-tax options.

[shERPA]

Perhaps.  Obviously we're talking about an HCE, so yeah, if s/he earns $130K gross, has a spouse earning $50K, normal personal deduction/exemptions, 401(k) deferrals, etc. probably land them in the 25% federal bracket.  Here in Taxifornia they would be in the 9.3% bracket and with AMT they don't necessarily get the benefit of the federal deduction for state taxes.  So call their current rate 33% combined.  Assume 15% fed and 9.3% state post retirement, standard deduction, so 24% combined.  Delta in income is $4,700 per year - $13,838 v. $9,117.  Still pretty significant. 

I will often bring this calculation with me when meeting with a prospect, it's more complicated of course because the owners are paying some costs for ee contributions and plan expenses, but the numbers are more dramatic too, especially when pitching a CB/(k) combo.  

Clients, CPAs and advisors tend to look at the one-year tax benefit vs the cost, but this significantly understates the value of tax-deferred saving.  

[austin3515]

I'm going to need to beef my own up.  I've done a lot with Access so I might do an Access program.  Very interesting...  I like the idea of the marketing tool as well.  Thanks!