Unlimited IRAs.UNDER current law, individuals are allowed to contribute a maximum of $2,000 a year to an Individual Retirement Account. Assuming a 5 per cent nominal return nominal return The rate of return on an investment without adjustment for inflation. While nominal return is useful in comparing the returns from different investments, it can be a very misleading indication of true investor earnings on an investment. , a 60-year-old worker with 5 years to retirement who saves a fixed amount every year accumulates a nest egg Nest Egg A special sum of money saved or invested for one specific future purpose. Notes: Examples of the purposes for which nest eggs are usually intended include retirement, education, and even entertainment (vacations and cruises). that is worth 5.5 times the annual savings net of personal income taxes. That is, after paying the tax on his IRA Ira, in the Bible Ira (ī`rə), in the Bible. 1 Chief officer of David. 2, 3 Two of David's guard. IRA, abbreviation IRA. withdrawals, the saver is left with his principal investment plus a capital gain equal to 50 per cent of the annual investment. As the investment horizon increases, so do the benefits. If the saver is a 40-year-old with 25 years to retirement, the after-tax lump-sum distribution Lump-Sum Distribution A one time payment for the entire amount due, rather than breaking payments into smaller installments. Some lump-sum distributions receive special tax treatment. grows to 47.7 times the annual investment, with a cumulative after-tax capital gain equal to 22.7 times the annual investment. The combined impact of higher rate of return and longer investment horizon are multiplications. An increase in the nominal return from 5 per cent to 15 per cent and a lengthening lengthening (lengkˑ·the·ning), n the use of various massage or muscle energy techniques to relax and stretch muscle and connective tissue. of the investment horizon from 5 years to 25 years result in a lump-sum distribution after personal income taxes equal to 212.8 times the annual investment, a capital gain of 187.8 times the annual investment. Of course, the economics of non-IRA savings are quite different, because the interest generated by the savings is subject to ordinary income taxation. If on top of his $2,000 in IRA contributions a person decides to save an additional $100 annually, what happens? Consider the case of the 60-year-old worker who earns a before-tax return of 5 per cent. After 5 years he will have accumulated ac·cu·mu·late v. ac·cu·mu·lat·ed, ac·cu·mu·lat·ing, ac·cu·mu·lates v.tr. To gather or pile up; amass. See Synonyms at gather. v.intr. To mount up; increase. 5.3 times his annual savings. The capital gain declines from 50 per cent of the annual investment in an IRA to 30 per cent in the case of regular savings. Thus the IRA program yields 3.77 per cent more than the regular savings account Savings Account A deposit account intended for funds that are expected to stay in for the short term. A savings account offers lower returns than the market rates. Notes: . Because the IRA program increases the yield of savings, it increases the incentive to save. Expanding the program would increase it further. The IRA expansion that would yield the greatest incentive is one where no savings were taxed. However, that option may run into some political problems. First, even though the higher savings rate Savings rate Personal savings as a percentage of disposable personal income. may boost the economy, so that in the long run other tax revenues would increase, in the short run there would be an unambiguous tax-revenue shortfall Shortfall The amount by which the capital required to fulfill a financial obligation exceeds available capital. Notes: Shortfall risk is often combated with an efficient hedging strategy created by a fund, group, institution, or individual. . Second, complete tax exemption tax exemption, immunity from the requirement of paying taxes. Federal, state, and usually local law provide exemption from taxation for a wide variety of organizations, usually not-for-profit, such as churches, colleges, universities, health care providers, various of IRAs raises political-fairness issues, because some incomes would no longer be subject to taxes. Taxing IRA money when it is withdrawn, as is done under current law (back-loaded IRAs), addresses the fairness issue. We could solve the revenue timing problem by taxing the money before it is invested rather than upon withdrawal (front-loaded IRAs). Though it may seem counter-intuitive, front-loaded and back-loaded IRAs are equivalent on a net present-value basis. Consider the case of a 63-year-old saver who opens an IRA with $100 and earns 10 per cent for two years. Upon retirement he will receive a lump-sum distribution of $121, which will be subject to taxes. Assuming the retiree is in the highest tax bracket Tax Bracket The rate at which an individual is taxed due to a particular income level. Notes: Each income class is taxed at a different level. Generally, the more you make the more you are taxed. (currently 39.6 per cent) the net-of-tax lump-sum distributions will be $73.08. If, instead, he chooses a front-loaded IRA, his $100 contributions will be taxed immediately, and hence he will have only $60.40 to invest. Assuming he still gets a 10 per cent annual rate of return, at the end of two years he will receive . . . $73.08! Since both programs allow for the tax-free compounding of savings, and both programs tax income only once, from the saver's point of view they are equivalent. However, from the government's point of view, front-loading the taxes avoids a short-term revenue shortfall removing the last excuse for limiting the amount of money Americans can protect from double taxation.
IRA Regular Savings
Years 5% 10% 15% 5% 10% 15%
5 5.5 6.1 6.7 5.3 5.6 6.0
10 12.6 15.9 20.3 11.5 13.2 15.2
15 21.6 31.8 47.6 18.6 23.3 29.5
20 33.1 57.3 102.4 26.9 36.9 51.5
25 47.7 98.3 212.8 36.6 55.2 85.5
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