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Faculty Forum Papers

"April 1976 - How To Hatch A Nest Egg With Taxes You Don't Pay?" By

Peter Anton
March 5, 1976

Visions of Sugar Plums

Fantasize a little. Let's ask the IRS and the State income tax people to:

         Stop withholding income tax on part of our earned income

         Lend us each month, cumulatively, an amount of money equal to the amount formerly withheld for          taxes

         Allow us to retain the use of this borrowed money for as long as we like - 10, 20, 30 years          or more

         Charge us no interest for the use of money

         Permit us to use the money to earn interest or to invest in a mutual fund in the hope of                    making capital gains

         Defer income tax liability on such earned interest or capital gains so that we may reinvest the          gross amounts of such earnings.

     Fantasy? No. This is reality: all these provisions are in effect for the fortunate few, of whom we faculty members are some.

     What makes it possible for you to use otherwise-tax money in this way are the misleadingly named "tax-deferred annuity" plans. The name is doubly misleading in that (intelligently handled) part of the deferred tax can be avoided entirely, so that what began as a deferral of tax liability becomes in effect a partial exemption from tax liability; further, if you elect to participate in a TDA plan you do not thereby commit yourself to purchase an annuity, as we shall see.

The rest of the story

     The provisions described at the outset are not, of course, the whole story. The rest of it is:

     (1) You must forgo the present enjoyment of some of your current income by depositing a fraction of it to a TDA account; in short, you must set aside some money as savings. (Anyone who supposes this provision to be immediately disqualifying in his case because h e needs all of his net paycheck each month may be making a serious mistake!)

     (2) Tax on the tax-deferred income, and on the compound interest and/or capital gains accruing to the TDA account does come due, both on the principal and the interest on the interest or gains, in the year(s) in which funds are withdrawn from the account.

     (3) There is a "front-end load" payable to the carriers of these plans and deducted from each contribution as it is made, so that not all of the money deposited in such plans is "working". The three companies that are authorized by the State to offer TDA plans to us charge, respectively, 4 per cent, 5 per cent, and a charge higher than 5 per cent but not in general specifiable because the percentage is a function of the amount deposited.

Why the full story is a happy one

     As to (1):

     The income you forgo the present use of (i.e., save) is, in effect, partially "matched by otherwise-tax money. The rate of this "matching is a function of your federal and state marginal tax rates. (Simply adding together the percentages which represent the respective marginal tax rates will approximate the total effective marginal tax rate, but such an approximation will always be somewhat higher than you true effective total marginal tax rate, owing to the fact that federal and state taxes are inter-deductible.)

     The effect of such "matching" is easily calculated. If you TDA load (commission) is 5 per cent, the formula for calculating the amount of money you can put to work in your TDA account for a given amount of current income forgone is:

W = .95F/1-R

where W is your total "working dollars", F is the number of dollars you forgo the present use of, and R is you total federal-state effective marginal tax rate expressed as a decimal fraction.

Example: You are prepared to forgo the present use of $50 each month (F=$50) and you total effective federal and state marginal tax rate is 35 per cent (R=.35). Plugging these values into the formula:

W = .95*$50/1-.35 = $73.07

Outcome: Your paycheck's net is reduced by $50, but this $50 puts another $23.07 to work for you earning interest (as high, currently, as 8 per cent). This total of $73.07 is 46 percent greater than the amount forgone of you net paycheck - and any amount you choose to forgo, whether smaller or larger than $50, will put 146 per cent of that amount to work for you.

     If your marginal tax brackets are higher, you advantage increases too: if the total effective marginal tax rate is 50 per cent, W becomes 1.9 times F, so that each dollar forgone puts $1.90 to work! The advantage of the TDA over ordinary savings is startling, and this advantage is enhanced by the fact that while interest on ordinary savings is fully taxed as earned, interest in the TDA account is tax-deferred for further compounding.

     As to (2):

     You become liable for income taxes on any amount withdrawn from you TDA account in the year in which you withdraw it, but even if such withdrawals were to be taxed at your present marginal tax rates you would be much ahead for having had the fee use of otherwise-tax money and for the full compounding of untaxed interest. However, the expectation is that you will have much lower marginal tax rates when you make withdrawals from your TDA than you had when you were making contributions to it.

     Example: You go on a year's sabbatical at half pay and you are awarded a tax-free research grant for the period of your leave. You need more money for your year's living expenses than your half pay and grant will provide. You stop contributions to your TDA and make a partial withdrawal. Since your marginal tax rate is greatly reduced due to your having a taxable income that is only half your normal income, your tax liability on your TDA withdrawal is also reduced. The effect of this is a permanent exemption from tax for some of your pervious income.

     Example: You become ill for an extended period and draw only long-term disability insurance payments, and Social Security disability payments. None of this income is taxable. Again, you stop making contributions to your TDA and you can withdraw an amount from it such that your personal exemptions and your deductions fully offset the amount withdrawn, so that you have no tax liability at all on these funds. In this way thousands of dollars of tax-deferred income can become tax-exempt income. (But this is the hard way).

     Example: You make no substantial withdrawals until the time of your retirement. At that time you choose to purchase an annuity that will allow you to receive a monthly income for life, or over a specified number of years (there are many options). Your Social Security income is not taxable, nor is that part of your PERS annuity payments that represents a return of capital. Thus, a substantial part of your normal retirement income does not count as income for tax purposes, so that your marginal tax rates are relatively low. Even if your total retirement income from all sources, including your TDA annuity, were equal to your present salary, the income tax you would have to pay on that income would be lower than the tax you presently pay. (You also receive double personal exemption from age 65 on, as does your spouse.) So deferring tax liability until retirement is likely to result in partial tax exemption.

     As to (3):

     All that can be said about load is that it is unavoidable and that it is a small price to pay for the advantage of a TDA account. If your preference is to invest your funds in stocks, two of the TDA plans available to us offer that option. Note that if you were to choose instead to invest in a no-load mutual fund you would be making such investment entirely with after-tax moneys and consequently would have fewer dollars working for you there than would have in a TDA fund. Moreover, your income from the no-load fund would be taxable as earned. The price paid to avoid a small commission can be a large one!

     Some TDA plans have lower loads than others, but load is not everything. Other provisions of the several plans differ significantly as to withdrawal provisions, permissibility of switching funds back and forth from interest-earning to stock-investment, interest rate paid, annuity options, and annuity payout rates. This last consideration is especially important: for identical annuity options, how many dollars per month will a plan pay you in retirement for each thousand dollars of TDA accumulation? The amount of the load must be weighed against these considerations.

     Finally, the load burden may seem more bearable if you think of it as being borne by the borrowed tax moneys you TDA makes available to you. As rationalizations go, this one is less objectionable than most.

How to make the most of previous savings, if any

     Now, to expand on my cryptic observation that you may be making a mistake to rule out a TDA account for yourself at present because you require all of your present net pay for running expenses: if, nonetheless, you have managed to set aside some savings for use as emergency funds, you are in a position to start a TDA plan and to do so without impairing the availability of those funds. If your savings are now earning (fully taxable) interest at a bank, savings and loan society, or credit union, you can arrange to have a sum equivalent to the amount of your savings deducted from your paychecks and placed in an interest-bearing TDA account; you can then withdraw your savings from your present thrift-institution account and use them for living expenses. You cash position will be unchanged, but your earnings on your savings will be much greater than before because you will be receiving a higher rate of interest, tax-deferred, on a substantially larger capital, due to the "matching" tax money that will also be deposited to your TDA account (e.g., 146 per cent of your savings amount if the load is 5 per cent and the net of your marginal tax bracket is 35 per cent). You will not have to make any further contributions to your TDA account unless and until you feel able to do so, and your TDA funds are as liquid as your savings account were in that you can make a partial withdrawal of your money (if you have chosen a plan that permits this) or full withdrawal at any time.

     For those who can take advantage of a TDA plan, a thrift-institution account is not thrifty.

Strategy for impending retirement

      If your time of retirement is near, you are - or ought to be - in an especially good position to start a TDA account since your salary is relatively high and your expenses less than when your children were going to college. You should have substantial savings and you should also have considerably more money coming in each month than you require for running expenses. If this is your condition you can shelter from your current high tax rates the salary you will receive from now until retirement. You do this by contributing to your TDA account the maximum permissible amount for each remaining paycheck. (The maximum permissible contribution for a late starter could be of the order of $1000 per month.) You then invade your previous savings as necessary to defray your living expenses.

      In the time left for making contributions to your TDA account you will not get much benefit from the other provisions of the plan, but you will get the benefit of two significant tax breaks: your current taxable income will be so greatly reduced as to lower your current tax rate; you will also make withdrawals from your TDA account whether in a lump or in installments, at a time when your marginal tax rates will also be reduced. If effect you will have tax-sheltered your previous savings retroactively! Timely hindsight can be almost as good as foresight.

TDA accumulation and thrift-institution accumulation compared

      Currently 8 per cent interest, compounded annually, is available to TDA participants. Typical interest on time deposits at a thrift institution is currently 6 per cent. Using these rates of interest and assuming a 5 per cent load on TDA contributions we can make comparisons of outcome.

A. If your total effective marginal tax rate is 25 percent and you elect to forgo (save) $100 per month of your net pay, then:

At the end of year You will have forgone net pay of At 6%, taxable, your accumulation will total, net In TDA at 8%, tax-def'd your accum. is And TDA accum. exceeds thrift accum. by
1 $ 1200$ 1229$ 158529%
1518000 25545 4303969%
253000054773 115880112%
303600074981 179564 139%

B. Calculating on the same assumptions but for a total effective marginal tax rate of 35 per cent:

At the end of year You will have forgone net pay of At 6%, taxable, your accumulation will total, net In TDA at 8%, tax-def'd your accum. is And TDA accum. exceeds thrift accum. by

At the end of year You will have forgone net pay of At 6%, taxable, your accumulation will total, net In TDA at 8%, tax-def'd your accum. is And TDA accum. exceeds thrift accum. by
1$ 1200$ 1225$ 182749%
1012000 146422649581%
151800024341 49660104%
      Note that these calculations of outcomes assume no change in applicable interest rates over the indicated periods. These rates may be expected to change, up or down, over a period of years. Note also that much of the advantage of the TDA plan over ordinary savings plans is due not to the greater interest offered by the former but to the "matching" tax dollars the TDA plan allows you to employ, and to the compounding of tax-deferred interest in the TDA.

A special break for those who have not set up a TDA earlier

     The law provides a "catch-up" provision for anyone who has not contributed the maximum allowable annual amount to a TDA plan, or who has not contributed at all. In accordance with a fearfully complex formula, you can make up very large contributions from your salary to a TDA if you elect to do so. Anyone who has substantial savings in a thrift institution is in a position to do this, as described earlier. In any case, it is obviously to anyone's advantage to contribute as much as is permitted to a TDA at all times. (The permissible annual maximum too is calculated by a complex formula.)

A consideration for stock-market investors

In conclusion, here is a question for those who have preferred to invest available funds in securities and to manage their portfolios themselves: at your marginal tax rates, what average annual rate of increase from capital gains and dividends would you have to achieve in order to equal the accumulations on your capital that you could realize by having that capital supplemented by tax "matching" funds in a TDA at eight per cent annual interest? The investor who does not find the answer to this question unsettling compels my admiration while stretching my credulity.