$tarrBuck Report, July 16, 2006: Tax Shelter in Your Investment Plan

July 16, 2006

$tarrBuck Report, July 16, 2006: Tax Shelter in Your Investment Plan
by
R. M. Starr

Working Americans have a variety of tax shelter opportunities. Most major employers offer 401(k) plans, often including an employer contribuition. Additional variants — depending on your employment and tax situation include (traditional) IRA’s, Keogh’s, 403(b)’s, 457(b)’s, …. These earned-income tax shelters are powerful means of investing, providing increased profits and rapid capital accumulation. When you invest in your tax shelter you pay no current income tax on salary money you invest or on investment earnings in the account. You pay income tax later when you withdraw your money.
Why use tax shelter?: The tax shelter delivers more because the tax shelter pays its taxes later, much later. Meanwhile, money that would have been spent in taxes is earning profits that are reinvested. Tax sheltered money starts bigger and grows faster than taxable saving. Even after paying taxes there’s a lot more left!
Tax-deferred plans combine two investment powerhouses: tax shelter and compound returns. Your savings come from before-tax income. Money that would have been paid in taxes works for you instead, and the returns are reinvested untaxed. Taxes are paid only when the money is withdrawn, usually on retirement, years or decades after it is deposited. In the meanwhile, it has time to grow. Tax shelter lets it grow faster than in a taxable investment. “Compounding” means earning further profits on returns reinvested. Compounding is the financial miracle, allowing money to double and redouble in a few years. For example, at 10% annual growth, your money doubles in seven years and quadruples in fourteen.

An Example
The example of B. B. Boehmer illustrates the point. He’ll get considerably more from his tax shelter than he could from unsheltered investing:
Saving and investing without tax shelter
B. B. is in the 35% income tax bracket (combined Federal and state). On each additional dollar of income, he pays income taxes of 35¢. One way for B. B. to invest is fully taxable. B. B. pays taxes on his salary, invests from after-tax income, pays taxes on the investment profits, reinvests the remainder, and so forth …. He decides to save $300 per month.
B. B. faces a choice of investment alternatives. Saving $300 per month from age 45 until age 65, B. B. decides to invest in the stock market with an average annual return of 10% (6.5% after taxes). His expected accumulation calculates out to $139,770. He can then withdraw monthly spending of $1057 (after-tax) for twenty years. He’ll draw the balance down to zero by age 85. Earning 6.5% annually, he’s more than tripled his money — each month he can withdraw more than three times what he saved twenty years earlier. Every year, B. B. pays income taxes on this investment income, sharing his investment success with the Federal and state governments, making no use of tax shelter.

Tax sheltered saving and investing
Now let’s look at a tax-sheltered alternative. Since B. B. is now saving in a tax deferred way, he can put more money into the tax shelter than he did into taxable savings; he invests the money he would have paid in taxes into the tax shelter. He had been planning to save $300 per month in after-tax income. That’s $461.50 a month in before-tax income. He saves $461.50 a month for twenty years and invests in the stock market at the expected return of 10% per year. The tax savings show up each year: instead of growing at 6.5% after-tax, his money grows faster, at 10%. The taxes will be paid later, after the money has had a chance to grow.
After twenty years of saving this way B. B. expects to accumulate
$ 317,215 (before-tax), more than twice as much as taxable saving. Now it’s time for the payout. He spends the money over twenty years to age 85, running the balance down to zero. The tax deferred tax shelter will support monthly payouts of $ 3106 before-tax, equivalent to $ 2019 after-tax. That’s more than six times as much as B. B. saved monthly. It’s almost twice as much as taxable saving would have provided.

The chart below shows a payout projection including a comparison with the (less volatile) 5% and 7.5% yield alternatives. Even at 5%, the tax shelter provides a significantly higher return. The monthly payout after-tax with stock market investing in B. B. ‘s example is almost twice as much from the tax shelter as from unsheltered saving. Why? B. B. contributed equivalent amounts to the two plans; both plans paid their taxes at the same rates. The tax shelter delivers more because the tax shelter pays its taxes later, much later. Meanwhile, money that would have been spent in taxes is earning profits that are reinvested. tax shelter moneys start bigger and grow faster. Even after paying their taxes, there’s a lot more left!

——————————————-
RETIREMENT INCOME PROJECTION: B. B. BOEHMER

Age: 45 ; Retirement age: 65; Marginal income tax rate: 35%.

Taxable Savings Program

Saves $ 300 per month in after-tax income
Yield before-tax:            10%             7.5%             5%
Yield after-tax:             6.5%             4.9%             3.25%
Accumulated savings
at age 65:                   $ 139,770    $ 117, 480    $ 99, 230
After-tax monthly income
to age 85:                     $ 1057         $ 755             $ 556

Tax-Deferred Savings Program
Saves $ 300 per month in after-tax income PLUS deferred taxes of $161.50 = $ 461.50
Tax deferred yield:             10%           7.5%               5%
Accumulated savings
(before-tax) at age 65:      $ 317,215 $239,820         $ 183,120
Monthly income from
savings to age 85
Before-tax:                     $ 3106         $ 1898             $ 1189
After-tax:                         $ 2019         $ 1234             $ 773
———————————–

Bottom line: Use your tax shelter! Max out your contributions. Tax shelter lets your investment returns grow and grow.

(c) Copyright R. M. Starr 2006

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