$tarrBuck Report for August 27, 2006: I guess it’s cheaper…I’ll have to keep him! Get me a justice of the peace!

August 27, 2006

$tarrBuck Report for August 27, 2006: I guess it’s cheaper…I’ll have to keep him! Get me a justice of the peace!

by R. M. Starr

Stacey and Richard are having another one of their kinder gentler /arguments/ discussions. At this rate, isn’t about time they got married?

Stacey: So how was the first day of medical school?

Richard: It’s going to be a long haul. Four years to the degree. Studying all day and all night. No income. Tuition and fees. I don’t see how we can keep it up. There’ll hardly be time to sleep, let alone sleep with you!

Stacey: Hey, it won’t be that bad. I’ve started as a junior associate at Dewey Cheatham and Howe LLP. I’m making six figures; we’ll get along. My sixteen hour days are as long as yours. If we’re not going to have time for sex, maybe we should get married.

Richard: It’s a little late now! You don’t need to make an honest man out of me.

Stacey: If you’re studying sixteen hours a day and exhausted the rest of the time, you’re useless as a boytoy. We’ll have to make you earn your keep in other ways.

Richard: What? What do you mean? You’re looking sneaky. What do you have in mind?

Stacey: Silly! When we get married you can be my tax deduction.

Richard: Tax deduction? Now you really have lost your mind. Everyone knows there’s a marriage tax. Taxes are more expensive for a married couple than for singles.

Stacey: You never did take tax law, did you? You’re half right. When two people with about the same income get married, their income tax goes up. But when their incomes are very different — one low, the other high — it works the other way round. With you earning nothing and me getting a lawyer’s salary, as my husband you can save me $800 a month in taxes. That’s state and Federal. It’s like you’re paying rent — or like the IRS is paying for our honeymoon.

Richard: But six years from now when I’m in practice — then the situation will be reversed. We’ll have to pay them for being married.

Stacey: Now you’ve got it.

Richard: So would it make sense to split up then?

Stacey: “Well you give me all your lovin’ and your turtledovin’
All your hugs and kisses and your money too.
You know you love me baby, still you tell me, baby
That some day, well, I’ll be blue.

Well that’ll be the day, when you say goodbye
That’ll be the day, when you make me cry
You say you’re gonna leave me, you know it’s a lie
Cause that’ll be the day that I die.”

Darling. Please don’t get any bright ideas. With the pre-nup I’ll write for us, you can’t afford to leave. Not in six years, not ever. Of course, you should consult your attorney before you sign it.

Richard and Stacey agree. They both wonder: How did he ever get along without her?

When does marriage make financial tax sense?
One low income, one high income. That’s the graduated income tax. Tax rates go up more than proportionately with income. As singles, the high income person has a high tax rate, the low income one, a low tax rate. Combined they come out lower than their average.

You can work it out on TurboTax. When two single people planning to marry have one low income and one high income between them. Then the Internal Revenue Service pays for the wedding.

(c) Copyright R. M. Starr 2006

$tarrBuck Report for August 20, 2006: Borrowing to Save

August 20, 2006

$tarrBuck Report for August 20, 2006: Borrowing to Save

by R. M. Starr

Richard and Stacey are having one of their kinder gentler /arguments/ discussions.

Richard: Darling! Have you completely lost your mind? From now on I’m managing the money!

Stacey: But it makes perfect sense!

Richard: No it doesn’t! No more than dating for chastity or feasting for weight-loss!

Stacey: Borrowing to save does too make sense. Let me show you.

Here’s Stacey’s plan:

Take out an equity line of credit on the house. Borrow $750 a month, contribute $1250 a month by payroll deduction to Stacey’s 401(k) plan at work. Stacey’s combined state and Federal income tax rate (on each additional dollar of income) is 40% so $750 is enough to make up for the lost after-tax income.

Interest on the equity line of credit is home mortgage interest; it’s tax deductible. Investment earnings on Stacey’s 401(k) are tax-deferred. They grow fast because they’re not slowed down by taxes.

The interest rate on the equity line of credit is 8%. Stacey figures that investments in the 401(k) will yield at least 8%. The interest expense after taxes is 4.8% annually, while the investment grows at 8%. Stacey works out the figures at http://www.moneychimp.com/calculator/compound_interest_calculator.htm .

Stacey figures the accumulated debt after 20 years, assuming she writes checks on the line of credit to cover interest payments. She credits back the income tax savings. Stacey figures the value of the investment in the 401(k) after it’s grown at 8%; then she figures the after-tax value assuming the tax rate stays the same.

Here’s how it works out with just one year’s worth of contributions held for the next 20 years.

Accumulated debt (compounded over 20 years at net interest cost of 4.8% annually): $23,460.

Accumulated 401(k) wealth (compounded over 20 years at 8% annually) before tax: $73,900. After-tax: $44,340.

Bottom line on borrowing to save for a year: It costs $23,460 to earn $44,340. That’s a painless profit of over $20,000 for one year’s worth of participation and twenty years waiting.

How about doing it every year for twenty years? Accumulated debt is $302,500 and after tax 401(k) wealth is $444,600. That’s a net after tax of $142,100 with no reduction in current spending. It’s free money.

What can go wrong with Stacey’s plan?
o Investment yields may not work out.
o Interest rates on the line of credit may go up.
o Tax rates may go up.
o To sustain hundreds of thousands in debt, more than a line of credit may be needed. Richard and Stacey may need to refinance the house.

Even if everything goes according to Stacey’s plan, when is Richard right? How can borrowing to save be a bad idea?
o What if they need the money? Children’s college tuition, move to a new house, losing a job, disability. Those are all reasons why the line of credit may not be available or the money may be needed for other things. Then locking up the line of credit to support the 401(k) may look like a mistake. Still, it’s possible to borrow against the 401(k), or to take a hardship withdrawal from the 401(k) (possibly with a penalty charge).

Stacey’s bottom line: Free money is well worth the risk. We’ll plan for big expenses and stop adding to the 401(k) when we really need the money. We’ll rethink it when we hit the ceiling on the amount we can borrow back from the 401(k).

Richard’s bottom line: Stacey is a financial genius. She should always manage the money. Borrowing to save makes perfect sense. We’ll start borrowing to save on Monday morning. Meanwhile it’s time to kiss and make-up.

(c) Copyright R. M. Starr 2006

$tarrBuck Report for August 13, 2006: 401(k) — Traditional or Roth?

August 13, 2006

$tarrBuck Report for August 13, 2006: 401(k) — Traditional or Roth?

by R. M. Starr

“Paper or plastic?” “Decaf or regular?” “Original or extra crispy?” “Traditional 401(k) or Roth?”

Paper, regular, extra crispy. I’ll have to get back to you on the 401(k).

Beginning this year many employers offer their workers a choice of 401(k) defined contribution retirement plans: Traditional or Roth. The big difference is that in the traditional plans all of the taxes are deferred and the income is taxable when withdrawn, but with Roth plans the contributions are made with after-tax income and no tax is due on a qualified withdrawal. The contribution limits are the same with both plans.

The first point to remember is that 401(k)’s are excellent investment vehicles. That’s true for their cousins 403(b) and 457(b) too. Tax-deferral means that money contributed grows faster than in taxable investments because taxes don’t slow down their growth. They only get taxed once: at the end of their growth in traditional plans, at the start in Roth. If tax rates are the same at the start and the end then the payoffs are the same.

What’s your tax bracket?
When you pay income taxes, your tax bracket is the additional tax you pay on each additional dollar of taxable income, also known as your marginal tax rate. Your Federal income tax bracket at low income (with two children) could be as low as negative 40% (including the earned income tax credit); the Internal Revenue Service pays you! For higher income earners who don’t qualify for the EITC, Federal tax rates start at zero and go as high as 35% (you pay them). State income taxes add on. Generally, as your income goes up, so does your tax rate.

When is traditional right for you?
If you’re in a high tax bracket now, and expect to be in a lower tax bracket on retirement (or whenever you take a withdrawal from your account) traditional is right for you. Don’t pay those high taxes now. Wait for a lower tax rate later. However, if you’ve planned and funded your retirement well, you’ll have roughly the same income in retirement as while you’re working. Then the tax rates will be the same. Postponing the tax bite on your initial contribution won’t do you much good.

When is Roth right for you?
If you’re in a low tax bracket now, and expect to be in a higher tax bracket on retirement or withdrawal, then the Roth really makes sense. Of course you have to be able to afford to defer the income. A low-income (and low tax-bracket) student or part-time worker who can rely on support from family should find the Roth plan a really great deal.

What about contribution limits?
Contribution limits are $15,000 in a calendar year, $20,000 at age 50 and over. The limits are the same for Roth and traditional. But Roth contributions come from after-tax income. If you’re up against the contribution limits in your traditional plan and want to contribute more, switch to Roth. You’ll be squeezing more after-tax dollars into your plan.

What about early withdrawal?
401(k) plans are for patient money. If there’s a chance you’re going to need the money soon, don’t put it into a retirement plan. There are limits and penalties for early withdrawal. But if an early withdrawal is needed, the withdrawal is taxable income. In a traditional plan none of the money has been taxed before; all of the withdrawal is taxable. In a Roth plan, some of the money has already been taxed — it doesn’t get taxed again. The proportion that hasn’t been taxed before gets taxed on withdrawal. An early withdrawal is likely to occur during a financial emergency — a time when your tax rate is low anyway. If that happens, you’ll be happier with traditional — you don’t want to regret the taxes you paid when you contributed.

Bottom line
Tax deferral is good investment planning. Go for it! Go for traditional if your tax rate is high now and likely to get lower on withdrawal. Go for Roth if your rate is low now and likely to get higher. Go for Roth if you’re up against contribution limits and want to squeeze more after-tax income into your plan.

(c) Copyright R. M. Starr 2006

$tarrBuck Report for August 6, 2006: Immediate Annuity?

August 6, 2006

$tarrBuck Report for August 6, 2006: Immediate Annuity?

by

R. M. Starr

An immediate life annuity is an insurance product that pays you a regular income for life, in exchange for a lump sum to purchase it now. It’s the precise opposite of life insurance — life insurance insures you against dying too soon; a life annuity insures you against outliving your money.

You pay for an immediate annuity now and it starts paying off directly, a check next month and each month thereafter. That makes it a lot simpler and more reliable than a deferred annuity (which starts paying off in the distant future) or a variable annuity (whose payoffs are keyed to the stock market).

Hammond Blackwell has managed his own money throughout his life. At his next birthday he’ll be 70 years old. Hammond’s mother just celebrated her 97th birthday. Hammond hasn’t been planning to live to 97 — but in case he does, he’d like some income security. He’s looking into buying a life annuity as a 70th birthday present for himself.

Hammond gets a quote from an insurance broker: For $500,000 now, Hammond can receive a monthly income of $3800 for life. If he lives as long as his mother, Hammond can receive $1,230,000, more than twice as much as his cost. But that calculation ignores the time value of money. Long term high grade corporate bonds are currently paying 6% annually. At that rate, $3800 per month for 27 years is currently worth about $600,000, more than Hammond’s cost but not such a bonanza. Nevertheless, that would be a good, and profitable deal. To do this bit of figuring Hammond could use the NPV function on Excel or go to http://www.moneychimp.com/calculator/retirement_calculator.htm .

But Hammond is not likely to live to 97. He looks up his life expectancy at http://www.cdc.gov/nchs/data/nvsr/nvsr54/nvsr54_14.pdf . At age 70 he’s likely to live another 13.5 years. At that rate, for his $500,000 he’ll collect $616,000. That’s more than it cost him, but actually, considering the time value of money, that stream of payments for 13.5 years is only worth $415,000. Insuring against outliving his money is costing Hammond $85,000. Is that too much? The break-even life expectancy is 18 years, 4.5 more than average.

There’s a reason it costs extra to buy the annuity. Not everyone buys one. People who don’t expect to live very long don’t buy annuities. So the life expectancy of the average annuitant is longer than the general population’s. For the insurer to break even, the annuity has to be priced assuming Hammond will live longer than the average American man. For the average American with an average lifespan, an annuity is not a financially winning investment.

Saving for retirement
There’s always the alternative of saving, investing and spending income and some principal. Hammond can create his own annuity plan. For $ 500,000 over 27 years, Hammond figures he can arrange a monthly income of $3150. That’s less than the annuity, but he’d maintain control. Or he could start with $600,000 and maintain the payout of $3800 for 27 years. But what if he lives too long? Mom is still going strong at 97. That’s the insurance value of the life annuity; it goes on as long as you do.

Waiting to buy the annuity
The longer you live, the shorter your remaining lifespan. If Hammond waits to age 80 to buy his annuity, he can get the same stream of payments for $350,000, and that’s in money a decade from now. If it’s earning interest in the meantime, it’s costing less in today’s dollars.

What about Inflation?
Even at moderate inflation rates, the value of $3800 a month can be cut in half over 27 years. It’s hard to find an annuity with a cost of living escalator. There are annuities available with a monthly payment that grows by a fixed percentage each year. But the starting monthly payment is reduced to make up for it. Not a good deal. To handle inflation, recognize that the purchasing power of the monthly payment is going to go down: save part of each month’s income in the early years recognizing the need to supplement the annuity later —- or plan to buy a second annuity (and set aside money for it now) in the future.

Choose your insurer
When you buy an annuity, you want to insure your future. The insurer had better be there then too. Choose a financially sound company; check it out in Best’s pocket key rating guide: Life-health, available in major libraries.

Happy Birthday, Hammond!

(c) Copyright R. M. Starr 2006