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gains, in the year(s) in which funds are withdrawn from the account.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 | $ 1585 | 29% |
| 3 | 3600 | 3856 | 5146 | 34% |
| 5 | 6000 | 6724 | 9299 | 38% |
| 10 | 12000 | 15103 | 22963 | 52% |
| 15 | 18000 | 25545 | 43039 | 69% |
| 20 | 24000 | 38557 | 72537 | 88% |
| 25 | 30000 | 54773 | 115880 | 112% |
| 30 | 36000 | 74981 | 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 | $ 1827 | 49% |
| 3 | 3600 | 3821 | 5938 | 55% |
| 5 | 6000 | 6623 | 10730 | 62% |
| 10 | 12000 | 14642 | 26495 | 81% |
| 15 | 18000 | 24341 | 49660 | 104% |
| 20 | 24000 | 36108 | 83696 | 132% |
| 25 | 30000 | 50343 | 133707 | 166% |
| 30 | 36000 | 67579 | 207190 | 207% |
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.
