Bryan Caplan  

You Do the Math: Goolsbee on Retirement Investing

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After I do my taxes, I often start thinking about retirement planning. Here's an old NYT column where Austen Goolsbee gives some sage advice:

You probably have not given much thought to political tax risk, however, or perhaps have even heard of it. Yet the purely political question of what will happen to tax rates over the next 30 years has become one of the most important factors in thinking about tax-deferred savings accounts...

Future increases in tax rates potentially threaten to significantly reduce the value of your retirement savings and may even mean that you should not save in 401(k) accounts at all.

...Relative to a regular account... a 401(k) gives you a bonus. You get to put money into the account without paying income tax on it this year and you do not have to pay taxes as it builds up. You just pay income tax on the full amount at the very end when you finally pull out the money in retirement.

[...]

But the lurking catch is that the tax you will pay on your account will be at the rate in place when you retire, not the rate now. And that may be very different.

Currently, my wife and I max out our 401k-type options. My bet, as usual, is that things will work out pretty well. I don't think the U.S. is going to raise tax rates by more than 15 percentage-points in my lifetime (though I won't be surprised if the payroll tax cap goes away).

Still, if there were a convenient Java script somewhere that allowed me to simulate a variety of retirement plans under several different political scenarios, I'd leap at the opportunity to learn from it. Can anyone point me in the right direction?

HT: Mankiw


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COMMENTS (21 to date)
KipEsquire writes:

The only significant basis not to be indifferent between a traditional IRA and a Roth IRA is if you expect income tax rates to change between now and your retirement, as Goolsbee notes later in the piece. The financially literate have understood this ever since the Roth IRA was created.

His commentary also omits the implications of dying before you exhaust your retirement vehicles. Tax-advantaged accounts can get favorable carry-forward treatment upon passing to the beneficiaries in a way that taxable accounts cannot. This is the reason why the tax laws require people to take mandatory IRA/401(k) withdrawals starting at age 70.5.

Garrett Schmitt writes:

Try the calculators (particularly the "Retirement Shortfall") at the bottom of this page:

http://www.bbt.com/bbt/personal/solutions/investforfuture/default.html

I think the tax rates are implemented on post-retirement withdrawals.

Chuck writes:

I think the fact that most 401k plans include matching funds makes it near impossible for using them to backfire.

If I put in 10 dollars today that gets matched to 20 and then grows at 5% for 20 years, when I retire I take it out I have something like $50. If it gets taxed at a 65% tax rate when I take it out, I still have $18.

If I take it home and pay, say 30% taxes, then I have $7 to invest for 5% for 20 years. That leaves me with $18, assuming I pay no taxes on it over the 20 years or when I cash out my investment (like capital gains, etc).

If you do the same experiment at 10% return, then the tax rate on the 401k money has to be 60% for the return to be as poor as taking the cash home.

I think the bottom line is that the initial 100% return on investment combined with the tax free growth on that return is pretty hard to beat, especially when the alternative is going to get nickeled and dimed on taxes anyway.

And the other part of the equation is that the 401k crowd is a large and infuential consituency, and the 401k beneficiaries are sympathetic old folks, so it is hard to imagine the 401k getting singled out for gouging over other forms of savings.

ed writes:

Another important difference between Roth and traditional IRA: The contribution limits are the same for both, so in an after-tax sense you can effectively contribute more to the Roth, allowing you a bigger tax shelter than with the traditional IRA.

Ironman writes:

The easiest to use, simplest application to do this kind of math on the web is via one of my favorite sites, Moneychimp.

Their tool is built to compare Roth vs Traditional IRAs, but will allow you to factor in higher tax rates in retirement. I also highly recommend their Monte Carlo retirement simulator - the only downside is that the user interface is in the right hand margin of the page, rather than in the center, which makes the user interface a bit clunky, but that's just me as the econoblogosphere's reigning authority on online tools talking....

NickK writes:

Ah, but ed, recall that the Roth money has been taxed already at your current tax rate. Effectively you may feel like your are contributing "more", but the same contribution to a Traditional IRA or 401(k) also allows you a tax savings! Depending on your current tax rate, a contribution to a Traditional IRA may make more sense. Another subtle difference.

The following calculator lets you compare after-tax contributions to before-tax contributions while adjusting for current tax rates and future anticipated tax rates. I am not affiliated with the site in any way, but I am in the field. This is my first post after over a year of following the site. Thanks!

http://www.finance.cch.com/sohoApplets/RothvsRegular.asp

Joe Marier writes:

See, the evil thing about income taxes is that they rise for everyone every year no matter what, assuming that there is inflation and economic growth. That's what makes an unmatched 401(k) a bad deal for the young, assuming current tax law.

Joe Marier writes:

Plus, if you're already maxing out a Roth, or you don't qualify, the only way to get (additional) tax free income in retirement is munis or cash-value life insurance.

8 writes:

Have you ever looked at the age of most politicians? Also, the greatest threat will come from Social Security and Medicare. What's more likely than a tax increase is a benefit cut, since raising taxes on retirees in order to pay retirees would be asinine...but then again...

C L writes:

Remember that since you'll likely be withdrawing less than you currently earn (since you have enough to live on after the deposit), fewer of the dollars will be taxed at the highest bracket. Also, even if the tax rates go up, the bracket levels will also rise with inflation making it extremely likely that you'll be in a lower bracket at retirement than you are now.

Dan Weber writes:

Because multiplication is associative and commutative, given equal tax rates now and at retirement it doesn't matter if you pay now or later.

(savings * (1 - tax rate) * years of growth) = (savings * years of growth * (1 - tax rate)).

You don't just have to worry about differing income tax rates, though. Two other major wrinkles:

If you've invested in, say, the Vanguard 500, you would have very little taxes to pay year-to-year, as well as preferred long-term rates when you finally retire. You might end up with worse after-tax performance in a 401(K).

And if we more to a consumption tax, such as the FairTax, all that prepaying of taxes in a Roth will be for naught.

Mason writes:

where's the In-trade market to see how long ROTHs will be available?

I guess they'll be gone with-in 25 yrs, because they offer such great tax savings/revenue loss.

Lord writes:

NickK, Ed's point is you can't contribute as much to a Traditional as you can to a Roth since they have the same nominal limits. Future taxes displace some of the room available in them. Now if you aren't maxing it out, this doesn't matter.

Higher or lower taxes are difficult to say. Many will probably be lower because they will be paying gross rather than marginal rates. Others will have fortunes and will have higher rates. War raises rates while peace lowers them.

Gary Rogers writes:

First, it strikes me as wrong to be talking about modifying behavior to game tax policy rather than figuring out what is really the best investment for my money. Sure, it is good to save for retirement, but tax policy should have nothing to do with how much or where I invest. Second, our economy has already reached the point where it is too weak to withstand reasonable interest rates, much less punative tax rates. The government will first try to inflate the debt away, but the foreign investors who hold our bonds will not allow that to happen. I suspect the next step will be an attempt to increase taxes, but that too has its problems. In a weak economy it will put so many people out of work that high taxes will also be abandoned. With no credit to fall back on, our only choice will be to cut spending. It will be interesting to see what path we take to get there. It would certainly be much better if we came to that realization now while there are still some reasonably good choices.

Rachel Soloveichik writes:

You're forgetting the most important benefit of 401Ks for middle-class parents. College financial aid taxes parental savings at about 6% a year. In other words, a family pays tuition $6,000 higher if they have $100,000 in their checking account. However, the colleges don't look at 401ks at all. If a family has two kids four years apart this means that non-retirement savings are taxed at 50%.

Dan Weber writes:

However, the colleges don't look at 401ks at all.

ITYM
don't look at 401ks YET.

I'm not sure exactly what motivates the people who control financial aid, but I think it's only a matter of time before they go after that motherlode.

CFP, EA writes:

Remember that you won't be taxed at your top rate for every dollar withdrawn in retirement, but you do get a tax break at your highest current marginal rate right now.

For example, let's say that a successful economist such as yourself is in the 28% marginal tax bracket and you contribut $15,000. You save $4,200 in taxes, the full 28%.

Now it 20 years later, and you need to withdraw $100,000 (likely more than you actually will need to withdraw) to maintain your lifestyle. Let's say that you still have a house and mortgage. You itemized deductions should be at least $25,000 (state taxes, mortgage interest, charity, etc.). You also get personal exemptions of $3,400 (2007) or more if you're over 65. Let's also say that you're getting $25,000 in Social Security.

Look at the totals.
Income: $125,000 - $100k IRA + $25k SS (though this would be reduced a bit but too much work to figure out)
Deductions and Exemptions: $31,800

So, for you first $31,800 of withdrawals, you pay a 0% tax rate, assuming your married.

Using 2007 numbers, you pay 10% on the next $15,650.

Now we're up to $47,450 worth of income and you have paid much tax.

On the next $48,049 worth of income, you pay 15% tax.

Now, we're up to $95,499 worth of income.

For rest of the income, you'll pay 25% tax.

So for the total $125,000 worth of income, you pay a total of $16,148 in tax. That's an effective tax rate of 12.9%.

Let's come back to that $15,000 that you contributed this year and saved $4,200. In retirement, you'll pull it out and pay $1,938 in tax.

Unless you're in the 15% marginal tax bracket, use your 401k instead of a Roth or a taxable account.

B.H. writes:

Try BU Prof. Larry Kotlikoff's "ESP" software. You can plan your retirement and simulate with different tax scenarios.

DK writes:

Take all your home equity out and take a tax deduction, then put it all away in tax advantaged life insurance. Tax free retirement and tax advantaged payment to heirs.

Douglas Colkitt writes:

Java is a compiled, not interpreted language Bryan. There's no such thing as a java script, it would be a Java program.

Anthony writes:

The Roth vs. Traditional consideration usually neglects a third possibility. One can contribute to a Traditional IRA (or 401K) and then roll that over into a Roth before retirement. So a Traditional IRA might be the right choice even if you are in a higher tax bracket at retirement, so long as you're in a lower tax bracket any year before retirement that you're eligible for a rollover.

Personally I've been contributing mainly to tax deferred retirement accounts with the intention of rolling to a Roth during the first few years after I start my own business, although I might take at least partial advantage of the 2010 rollover madness (rollovers in 2010 won't be taxed until 2011/2012).

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