Tax-deferred savings plans.

Most taxpayers view tax-deferred savings (TDS) plans as desirable vehicles for reducing current income taxes and accumulating greater funds for retirement. Over the years, legislation has provided taxpayers with substantial tax incentives to save for their particular retirement needs, thereby boosting personal savings and economic growth in general.

All such tax laws share the same general principles: (1) annual contributions (savings) under tax-deferred plans are not subject to current taxation, (2) contributions by employers are currently deductible, (3) investment income is not subject to annual income taxes and (4) both contributions and investment income are taxed only when received by the individual on retirement in excess of the individual's tax basis. However, Congress has also passed a variety of penalty taxes constraining these plans.

Contrary to what many practitioners and their clients have been led to believe, TDS plans may not always be desirable. Depending on the rates of return on savings dollars and the tax rates before and after retirement, the spendable dollars at retirement under TDS could be greater or less than the spendable dollars under taxable saving plans with alternative comparable investments (ACIs). One should not set up a TDS plan to avoid a current income tax rate of, say, 15% and then end up paying 35% tax later on when retirement income is received. The tax deferral advantage of greater fund accumulation under TDS could be more than offset by a steep rise in the tax rate after retirement, or by a much higher rate of return under ACI. However, there could be substantial differences in the rates of return for different plans within either TDS or ACI.

A TDS plan has a definite net economic advantage (greater fund accumulation after tax) over ACI when the investor's marginal tax rate after retirement is lower than that before retirement, and the rate of return under TDS is greater than that under ACI. Even if one of these two conditions is not satisfied, the investor might still find TDS a viable investment if the tax disadvantage of TDS is more than offset by a TDS rate of return advantage over ACI, which is highly unlikely in an efficient financial market.(1)

This article will compare and analyze two distinct situations: in one, TDS is desirable; in the other, the individual is better off under alternative savings plans.

TDS Plans

The major individual plans are briefly described below. Table 1, on page 43, summarizes the major differences among these plans.

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* Individual retirement accounts (IRAs): IRAs must meet the requirements of Sec. 408(a). They provide the broadest eligibility provisions, allowing all persons under the age of 70 1/2 to set up an IRA. The annual deduction for contributions is limited to the lesser of 100% of taxable compensation or $2,000 (plus an additional $250 for a spousal account). The deduction is phased out for participants (or spouses) covered in an employer retirement plan as their adjusted gross income (AGI) exceeds certain levels (see footnote a to Table 1).

* Simplified employee pension (SEP) plans: When SEP plans meet the five requirements of Sec. 408(k), an employer can make annual contributions to an employee's IRA in an amount up to the lesser of 15% of compensation or $30,000. A main advantage of a SEP is that it eases the compliance and reporting obligations of the Employee Retirement Income Security Act of 1974 (ERISA) regarding vesting, funding and participation requirements. In addition, an employee may also make an annual contribution of up to $2,000 under the basic IRA provisions and limitations. A SEP plan is also subject to the minimum contribution rules on top-heavy plans.

* Keoghs: Self-employed individuals are subject to special retirement plan rules--called Keogh or H.R. 10 plans--under Sec. 401(c). A Keogh plan can be set up to benefit both the self-employed individual and his employees. A person who is both an employee covered under another pension plan and a self-employed person may still establish a Keogh plan for his income from self-employment activities. For a Keogh based on a defined contribution plan, a self-employed person can generally contribute the lesser of $30,000 or 25% of earned income from self-employment activities. Keogh plans are subject to top-heavy rules regarding coverage of key employees.

* Cash or deferred arrangements (CODAs): CODAs are governed by Sec. 401(k). CODAs allow eligible employees the flexibility to elect to receive a benefit directly as cash (taxable) or have the benefit contributed to a qualified retirement trust for their benefit (and not be currently taxed). Employees eligible to benefit must satisfy the coverage requirements of Sec. 410(b)(1), the most substantive requirement being that the plan must benefit at least 70% of employees who are not highly compensated employees. Employees' elective contributions vest immediately. The maximum annual deferral to a CODA changes annually with indexing (the amount as of Jan. 1, 1993 is $8,994). These plans have been growing in popularity as they enable employers to transfer pension obligations to their employees by shifting from defined-benefit to defined-contribution plans.

* Tax deferred annuities (TDAs): Under Sec. 403(b), TDAs benefit employees of tax-exempt organizations and public schools. Tax is not imposed when the annuity is purchased, but is instead deferred until the annuity payments are received. The annuity must be nonforfeitable and nontransferable. Employees can exclude up to 20% of their compensation, multiplied by their years of service, less total prior contributions, as an annual exclusion.

For purposes of this article, all of these plans will be referred to as tax-deferred savings (TDS) plans, with occasional reference to a particular plan when major differences exist.

1993 Tax Legislation

The Revenue Reconciliation Act of 1993 (RRA) increased individual tax rates by creating a fourth bracket of 36% on taxable income in excess of $140,000 for married filing jointly, or in excess of $115,000 for singles.(2) In addition, there is a 10% surtax on taxable income in excess of $250,000.(3) This surtax results in a marginal tax rate as high as 39.6% on taxable income in excess of $250,000. However, the maximum tax on long-term capital gains remains at 28%. This means there is a spread of 11.6% between the maximum tax rate on ordinary income and the tax rate on capital gains. The RRA also reduced from $235,840 to $150,000 the maximum annual compensation that can be considered for purposes of computing benefits-contributions-discrimination testing.

This tax increase will add to the tax advantage of tax-deferred savings of greater fund accumulations than under taxed investments. In other words, higher income tax rates increase the tax savings under tax-deferred savings and the compounding effect on these savings will result in greater fund accumulations than under taxed investments, other things being equal. Therefore, higher income tax rates make tax-deferred savings more attractive than ordinary savings.

Desirable Tax-deferred Savings

Basically there are two frequently touted major advantages of TDS plans over ordinary savings plans.(4) First, under TDS, individuals can avoid higher income tax rates on savings and investment earnings during working years and then be taxed at lower tax rates during retirement years. Second, this tax-deferred feature allows TDS to accumulate greater funds at retirement via the compounding effect than ACI plans.

These two advantages will be examined on the basis that the investor has one given average combined tax rate of Federal and state income taxes during working years and one average tax rate during retirement years. It is assumed that, unlike ACI plans, the individual can deduct annual savings and investment earnings from taxable income during working years under a TDS plan. Further, it is assumed that the rate of return before tax under both TDS and ACI is the same for comparable investments in an efficient financial market. This last assumption will be dropped later on when considering the possibility of different rates of return in taxed investment opportunities.

* Same tax rates before and after retirement If an individual's combined average Federal/state income tax rate is the same during working years and retirement years, TDS is definitely superior to ACI, other things being equal.

Example: Individual X, with an average tax rate of 25% during working years, saves $100 annually under a fully deductible TDS plan, such as an IRA. The fund accumulation under this TDS plan will amount to $3,679 after 20 years, or $15,476 after 40 years, invested at a compound annual rate of return of 6%.(5)

Under an ACI plan, the same $100 annual savings invested at 6% before tax will accumulate only $2,353 after 20 years, or $8,027 after 40 years.(6) This discrepancy is due to the fact that under ACI, the nondeductible annual savings of $100 provides only $75 of investable dollars after tax ($100 x (1 - 0.25)) that earn only 4 1/2% after tax (0.06 x (1 - 0.25)). Therefore, in ACI only $75 per year is invested (compounded) at 4 1/2% to provide a fund of $2,353 after 20 years, or $8,027 after 40 years.(7) The fund accumulation at the end of the savings period is greater under TDS than under ACI.

But this is only half the story. The fact of the matter is that any disbursements under TDS will be fully taxed as income at the current tax rates during retirement years. On the other hand, under ACI, both annual contributions and investment earnings were taxed before, and disbursements are not subject to income tax during retirement years. Consequently, the actual spendable dollars (after tax) at retirement under TDS will be only $2,759(8) after 20 years ($3,679 x (1 - 0.25)), or $11,607 after 40 years ($15,476 x (1 - 0.25)).

Clearly, TDS provides more spendable dollars (after tax) than ordinary savings (ACI) when the average tax rate is the same before and after retirement and the before-tax rates of return are the same. In the example, TDS provides $2,759 after 20 years, or $11,607 after 40 years, when compared to ACI of $2,353 or $8,027, respectively. While the discrepancy in spendable dollars between the two plans per $ 1 00 annual savings is only $406 in 20 years, it is $3,580 when the savings period is stretched to 40 years. Similarly, it is possible to prove that the discrepancy in spendable dollars at retirement widens if the comparable rate of return in both plans is higher than 6%, or when the tax rate before and after retirement in both plans is greater than 25%, and vice versa. In other words, TDS is even more favorable than ACI--the longer the savings period, the higher the rate of return or the tax rate, and vice versa.

Table 2, on page 46, compares the fund disbursements after tax per $1 annual savings under both TDS and ACI for selected interest rates before tax and tax rates for savings periods of 20 years and 40 years. From the table, the spendable dollars at retirement per $1 annual savings under TDS as compared to ACI after 20 years is $31.2678 versus $28.4049 at a rate of return before tax of 6% and a tax rate of 15%. But, the spendable dollars would be $48.6838 versus $41.1705, respectively, when the rate of return before tax is 10% instead of 6%.

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The table also reveals that the TDS advantage increases with higher tax rates. At a tax rate (before and after retirement) of 45%, the spendable dollars at retirement under TDS as compared to ACI would be $20.2321 versus $15.2381 at a 6% rate of return, or $31.5012 versus $19.1776 at a 10% rate of return before tax. Considering the extreme case in which the rate of return before tax (i) is 10% and the average tax rate before and after retirement is 45%, the spendable dollars at retirement per $1 annual savings after 40 years according to Table 2 would be $243.4259 under TDS compared to only $75.1331 under ACI. If the individual saves $1,000 annually, the fund disbursement after tax would be $243,426 under TDS and only $75,133 under ACI.

* Lower tax rates after retirement The scenario in which the individual's average income tax rate during retirement years is lower it than that during working years was originally perceived as the norm when advocating tax-deferred savings. Of course, this is the ideal situation: TDS proves even more superior than ACI simply because the individual avoids higher tax rates on savings and investment earnings during working years, to be taxed at lower rates during retirement years. It is not only the income-tax savings that count, but also the compounding factor that contributes to the fund accumulation during the savings period.

For instance, if X in the example expects an average tax rate of only 15% instead of 25% during retirement years, the annual savings of $100 under TDS (e.g., an IRA) will provide spendable dollars after tax of $3,127 after 20 years ($3,679 x (1 - 0.15)) rather than $2,759, or $13,155 after 40 years ($15,476 x (1 - 0.15)) instead of $11,607. Clearly, TDS provides more spendable dollars at retirement than ACI when the tax rate is lower than the rate during working years and the before-tax rates of return are the same, and is naturally even more superior the lower the individual average tax rate during retirement years is than the average tax rate during working years.

According to Table 2, spendable dollars after tax at retirement under TDS are always much higher the lower the tax rate is during retirement years. For example, $1 annual savings invested at 8% under TDS for 20 years would provide $29.7453 at disbursement when the average tax is 35%, or $38.8977 when the tax rate is 15%. If the same $1 annual savings plan continues for 40 years, TDS would provide $168.3867 at disbursement when the tax rate is 35%, or $220.1980 when the tax rate is only 15%.

Unfavorable Tax-Deferred Savings

Many taxpayers may find themselves in situations in which they would fare better under an ordinary savings plan than a tax-deferred savings plan. For example, if an individual expects a higher combined Federal/state income tax rate during retirement years than during working years; when the rate of return in alternative investments (not necessarily comparable), such as an investment in a successful small business, is high enough to more than offset the tax advantages of TDS; when the ACI income is substantially long-term capital gains and thereby taxed at lower rates than ordinary income under TDS. This is especially true under the RRA. A situation may arise when retirement savings might be needed for a possible emergency in the near future, when a Federal tax penalty of 10% is imposed on early withdrawals. In all of these situations, the individual might find that ordinary savings plans are more favorable than tax-deferred savings plans.

* Higher tax rates at retirement In this situation, the individual projects a substantially higher Federal/state income tax rate during retirement years than during working years. There are many reasons why such a situation is possible. First, the normal lifetime income cycle indicates that personal income (and wealth) increases at an exponential rate during the final working years and so does the income tax rate. Second, by retirement age many people would have lost many tax write-offs, such as personal exemptions for dependents and interest payments on a home mortgage. Third, during retirement, part of social security income could be subject to Federal income tax. Fourth, many people under normal or early retirement continue to work or have a substantial income from investments, which, when added to their retirement income, could result in higher average tax rates during retirement years than the rates paid before, during working years. Fifth, the tax bracket creep due to inflation that is compounded over long periods of time would drastically increase the dollar income to retirees.

As mentioned before, it does not make any sense for anyone to make a deductible contribution to an IRA today just to avoid a combined tax rate as low as 10% or 15%, and then end up paying a much higher tax rate of 40% or 50% later on the fund disbursements. For instance, in the example, if the average tax rate during retirement years is 50% instead of 25%, the spendable dollar (after tax) at retirement under TDS will be $1,840 after 20 years ($3,679 x (1 - 0.50)), or $7,738 after 40 years ($15,476 x (1 - 0.50)), much lower than $2,353 and $8,029 under ACI, respectively.

* Higher rates of return under taxed investment The analysis so far has assumed that both TDS and ACI earn the same rate of return before tax in comparable investments, 6% in the example. Clearly this is a reasonable assumption for comparable investments in an efficient financial market where any differences in the rate of return will be short-lived. Some might argue that TDS represents a larger and more diversified investment portfolio than an ordinary savings plan. This argument is not warranted considering the vast development of mutual funds with similar investment attributes. Today, mutual funds provide for the investment of periodic savings in different securities of common stocks, bonds and tax-exempt municipals.

But what about the individual who could earn a much higher rate of return, such as 20%, 30% or even 50% in uncomparable investments? For example, an individual whose own successful small business garners a higher rate of return than the 6%, 8% or even 12% earned under TDS could, other things being equal, easily find that savings reinvested in business will accumulate a much greater fund at retirement than TDS.

Penalty Taxes

Tax-deferred savings have the potential of incurring additional taxes besides the income tax. These additional penalty taxes vary somewhat among TDS plans, and some are imposed annually until a violation is corrected.

Early withdrawals before the age of 59 1/2 result in an additional tax of 10% on the amount that is includible in income. Also, excess distributions from a retirement plan--i.e., in one calendar year a distribution exceeds the greater of $150,000, or a dollar amount annually adjusted for cost of living increases [$144,551 as of Jan. 1, 1993)--are subject to a 15% nondeductible excise tax.

Excess accumulations on the death of an individual are subject to a 15% estate tax under Sec. 4980A. Excess accumulations are defined as the excess of the value of the individual's interests in retirement plans over the present value of a hypothetical single life annuity with annual equal payments. On the other hand, excess contributions to a retirement plan in excess of permissible amounts are subject to a 10% excise tax (6% for IRAs and Sec. 403(b) plans).

Minimum distributions must generally be made to participants starting the calendar year following the year the individual reaches The penalty is a nondeductible excise tax of 50% of the underdistributed minimum distribution. Distributions of retirement benefits to heirs after death are subject to income taxation (income in respect of a decedent) to the heirs. In addition, the values of retirement plans can also be included in the taxable estate of the decedent (unless there is something to offset it, such as a marital deduction by the spouse). This can create double taxation (income tax plus estate tax) on retirement benefits. Sec. 691(c) allows a deduction to the heir reporting the income from the retirement plan for the proportionate estate taxes paid by the estate. However, the deduction is a miscellaneous itemized deduction and is subject to the 2% of AGI floor. The effect is to possibly reduce or even eliminate the income tax deduction, which then exposes retirement benefits to double taxation.

Another way TDS income can cause additional taxes is by increasing AGI, thereby subjecting more social security income to tax. The current maximum social security benefit under the RRA that can be taxed has been increased from 50% to 85%.

Conclusion

Tax-deferred savings plans receive favorable tax treatment during the period of savings accumulation. Subject to some limitations, neither the annual savings nor the investment income is subject to income taxation during the accumulation period. This tax advantage together with the compounding effect allows the accumulation of greater funds under TDS than under ordinary savings plans. Given the same tax rates before and after retirement and the same rates of return before tax in comparable investments, TDS provides greater fund disbursements after tax at retirement than ordinary savings. This advantage increases with the increase in the rate of return, the accumulation period, or the tax rate, and vice versa. The new increased Federal income tax rates for upper income brackets will make TDS more favorable than ordinary savings, other things being equal.

On the other hand, tax-deferred savings might be unfavorable to many individuals with higher average income tax rates after retirement. Also, some individuals might be able to earn a much higher rate of return before tax than that of TDS by investing in, for example, a successful small business. In such cases, the average tax rate after retirement and/or the rate of return in other investments could be high enough to offset the TDS advantage. In addition, tax-deferred savings are clouded with a variety of tax penalties. Individuals who are likely to become victims of such penalties might be better off under ordinary savings plans. Finally, the Revenue Reconciliation Act of 1993 favors alternative taxed investments by taxing long-term capital gains at lower rates (maximum 28%) than ordinary income under TDS. In addition, fund accumulations under TDS could result in higher taxes on social security income received after retirement. (1) See Gahin and Bagley, "When and Where to Invest in Tax-Deferred Saving Plans," XLV Journal of the American Society of CLU and ChFC 66 (jan. 199 1). See also the warnings against the rush to set up IRAs or similar TDS plans in Adelman and Dorfman, "A Comparison of TDA and Non-TDA Investment Returns," XLIX The Journal of Risk and Insurance 73 (Mar. 1982); Gahin, "The Financial Feasibility of Tax-Sheltered individual Retirement Plan," XLX The Journal of Risk and Insurance 84 (Mar. 1983); and Robbins and Robbins, "Taxing the Savings of Elderly Americans," The National Center for Policy Analysis, Report No. 141 (Sept. 1989), Dallas, Tex. (2) RRA Section 13201(a), amending Sec. 1(a) and (c). (3) RRA Section 13202. (4) There are two other minor tax advantages of TDS over ordinary savings: (1) Income taxes may be lower on a lump-sum distribution by electing five-year averaging (10 years if the taxpayer was 50 years old before Jan. 1, 1986), providing that distribution was made either after attaining age 59 1/2, or because of death, separation from service or disability. (2) The tax deferral might be extended by a tax-free rollover when the funds are transferred to an IRA within 60 days of the distribution. (5) At 6%, the future value of a $1 annuity is a factor of $36.7856 after 20 years, or $154.7620 after 40 years. To get the fund accumulation for $100 annuity annual savings, multiply this factor by $100. (6) At 41/2%, the future value of a $1 annuity is a factor of $31.3714 after 20 years, or $107.0303 after 40 years. To get the final accumulation of $75 annual savings after tax $100 (1 - 0.25), multiply this factor by $75. Table 2 on page 46 gives the same result when out of $1 annual savings only $0.75 after tax is invested at 4 1/2% after tax under ACI to accumulate $23.529 after 20 years, or $80.2727 after 40 years. When these factors are multiplied by $100, the result is $2,353 after 20 years, or $8,027 after 40 years, the same as above. (7) See note 5. (8) Table 2 gives fund disbursement after tax at retirement under IDS of $1 annual savings invested at 6% if fund disbursements are taxed at 0.25, which is a factor of $27.5892 after 20 years, or $116.0715 after 40 years. When these factors are multiplied by $100, the result is $2,759 after 20 years, or $11,607 after 40 years, as shown above.