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To evaluate the trade-off, Spreadsheet 18.8 modifies Spreadsheet 18.7 (progressive tax) to
conform to the features of a Roth IRA, that is, we eliminate deductibility of contributions and
taxes during the retirement phase. We keep consumption during the earning years the same as
they were in the benchmark (traditional IRA) tax shelter to compare the standard of living in
retirement afforded by a Roth IRA tax shelter.
Table 18.2 demonstrates the difference between the two types of shelters. The first line
shows the advantage of the traditional IRA in sheltering contributions. Taxes paid during the
working years are lower, yet taxes during the retirement years are significant and, later in life,
you pay less tax with Roth IRAs (line 2). For the middle-class income we examine here, this
is not sufficient to make Roth IRA more attractive, as the after-tax annuities demonstrate. The
reason is that early tax payments weigh more heavily than later payments. However, one can
find situations in which a Roth IRA will be more advantageous. This is why it is important for
investors to check their unique circumstances. Those who are not able to do so themselves can
log on to one of the many websites that provide tools to do so (e.g., http://www.quicken.com).
Notice in Table 18.2 that the lifetime tax rate for saving with traditional IRAs is 39.37%.
This is a result of large accumulation of earnings on savings that are taxed on retirement and
shows the importance of early accumulation. Despite the higher lifetime taxes, this tax shelter
ends up with larger after-tax real consumption during retirement.


S P R E A D S H E E T 18.8
Roth IRA with a progressive tax


A B C D E F G H
1 Retirement Years Income Growth Rate of Inflation Exemption Now Tax Rates in Savings Rate ROR rROR
2 25 0.07 0.03 10000 Table 18.1 0.15 0.06 0.0291
3 Age Income Deflator Exemption Taxes Savings Cumulative Savings rConsumption
4 30 50,000 1.00 10,000 8,000 6,300 6,300 35,700
5 31 53,500 1.03 10,300 8,640 6,793 13,471 36,958
9 35 70,128 1.16 11,593 11,764 9,370 52,995 42,262
19 45 137,952 1.56 15,580 28,922 19,707 278,528 57,333
29 55 271,372 2.09 20,938 64,661 41,143 883,393 79,076
39 65 533,829 2.81 28,139 145,999 92,460 2,432,049 104,970
40 Total Total 632,759 1,752,425 1,163,478 Real Annuity 49,153
41 RETIREMENT Tax factors
42 Age Nom Withdraw Deflator Interest Exemption Taxes Funds Left rConsumption
43 66 142,460 2.90 137,375 28,983 0 2,435,512 49,153
47 70 160,340 3.26 135,579 32,620 0 2,404,847 49,153
52 75 185,879 3.78 125,770 37,816 0 2,233,096 49,153
57 80 215,484 4.38 103,778 43,839 0 1,846,348 49,153
62 85 249,805 5.08 64,070 50,821 0 1,146,895 49,153
67 90 289,593 5.89 -984 58,916 0 0 49,153
68 Total 2,450,313 0




Traditional IRA Roth IRA
TA B L E 18.2
Taxes:
Traditional vs. Roth
Earning years $ 879,430 $1,752,425
IRA tax shelters
under a progressive Retirement years 1,797,848 0
tax code
Total paid over lifetime 2,677,278 1,752,425
Retirement annuity:
Before-tax $83,380 $49,153
After-tax 66,366 49,153
Lifetime tax rate 39.37% 29.19%
Bodie’Kane’Marcus: VI. Active Investment 18. Taxes, Inflation, and © The McGraw’Hill
Essentials of Investments, Management Investment Strategy Companies, 2003
Fifth Edition




637
18 Taxes, Inflation, and Investment Strategy



<
7. Suppose all taxpayers were like you, and the IRS wished to raise a fixed tax reve-
Concept
nue. Would it be wise to offer the Roth IRA option?
CHECK

401k and 403b Plans
These days the majority of employees receive retirement benefits in the form of a defined con-
tribution plan (see Chapter 17). These are named after the relevant sections of the U.S. tax
code: 401k in the corporate sector and 403b in the public and tax-exempt sectors. These are
quite similar and the discussion of 401k plans applies to 403b plans as well.
401k plans
401k plans have two distinct features. First and foremost, your employer may match your
contribution to various degrees, up to a certain level. This means that if you elect not to par- Defined employee
ticipate in the plan, you forego part of your potential employment compensation. Needless to contribution plans
say, regardless of tax considerations, any employee should contribute to the plan at least as wherein the employer
matches the
much as the employer will match, except for extreme circumstances of cash needs. While
employee™s
some employees may face cash constraints and think they would be better off skipping con-
contribution up to
tributions, in many circumstances, they would be better off borrowing to bridge the liquidity a set percentage.
shortfall while continuing to contribute up to the level matched by the employer.
The second feature of the plan is akin to a traditional IRA in tax treatment and similar in
other restrictions. Contributions to 401k plans are restricted (details can be found on many
websites, e.g., http://www.Morningstar.com), but the limits on contributions generally exceed
the level matched by the employer. Hence you must decide how much of your salary to con-
tribute beyond the level matched by your employer. You can incorporate 401k plans, like the
traditional IRA, in your savings-plan spreadsheet, review the trade-off, and make an informed
decision on how much to save.

Risky Investments and Capital Gains as Tax Shelters
So far we limited our discussion to safe investments that yield a sure 6%. This number,
coupled with the inflation assumption (3%), determined the results of various savings rules
under the appropriate tax configuration. You must recognize, however, that the 6% return and
3% inflation are not hard numbers and consider the implications of other possible scenarios
over the life of the savings plan. The spreadsheets we developed make scenario analysis quite
easy. Once you set up a spreadsheet with a contemplated savings plan, you simply vary the
inputs for ROR (the nominal rate of return) and inflation and record the implications for each
scenario. The probabilities of possible deviations from the expected numbers and your risk
tolerance will dictate which savings plan provides you with sufficient security of obtaining
your goals. This sensitivity analysis will be even more important when you consider risky
investments.
The tax shelters we have described allow you to invest in a broad array of securities and
mutual funds and you can invest your nonsheltered savings in anything you please. Which
portfolio to choose is a matter of risk versus return. That said, taxes lend importance to the
otherwise largely irrelevant aspect of dividends versus capital gains.
According to current U.S. tax law, there are two applicable capital gains rates for most in-
vestments: 20% if your marginal tax rate is higher than 27.5%, and 8%5 if you are in a lower
tax bracket. More importantly, you pay the applicable rate only when you sell the security.
Thus, investing in non-dividend-paying securities is an automatic partial tax shelter with no
restrictions on contributions or withdrawals. Because this investment is not tax deductible, it


5
The rate goes up to 10% if you hold the security for less than five years.
Bodie’Kane’Marcus: VI. Active Investment 18. Taxes, Inflation, and © The McGraw’Hill
Essentials of Investments, Management Investment Strategy Companies, 2003
Fifth Edition




638 Part SIX Active Investment Management



SPREADSHEET 18.9
Saving with no-dividend stocks under a progressive tax


A B C D E F G H
1 Retirement Years Income Growth Rate of Inflation Exemption Now Tax rates in Savings Rate ROR rROR
2 25 0.07 0.03 10000 Table 18.1 0.15 0.06 0.0291
3 Age Income Deflator Exemption Taxes Savings Cumulative Savings rConsumption
4 30 50,000 1.00 10,000 8,000 6,300 6,300 35,700
5 31 53,500 1.03 10,300 8,640 6,793 13,471 36,958
9 35 70,128 1.16 11,593 11,764 9,370 52,995 42,262
19 45 137,952 1.56 15,580 28,922 19,707 278,528 57,333
29 55 271,372 2.09 20,938 64,661 41,143 883,393 79,076
39 65 533,829 2.81 28,139 145,999 92,460 2,432,049 104,970
40 Total 1,752,425 1,163,478 Real Annuity 49,153
41 RETIREMENT Tax rate on capital gain 0.08 0.2
42 Age Nom Withdraw Deflator Cum cap gains Exemption Taxes Funds Left rConsumption
43 66 142,460 2.90 1,340,186 28,983 0 2,435,512 49,153
47 70 160,340 3.26 1,561,124 32,620 5,504 2,404,847 47,466
52 75 185,879 3.78 1,660,844 37,816 7,874 2,233,096 47,071
57 80 215,484 4.38 1,503,386 43,839 10,416 1,846,348 46,778
62 85 249,805 5.08 995,489 50,821 13,204 1,146,895 46,555
67 90 289,593 5.89 1,500 58,916 16,471 0 46,358
68 Total 1,056,691 236,555




is similar to a Roth IRA, but somewhat inferior in that you do pay a tax on withdrawal, how-
ever low. Still, such investments can be more effective than traditional IRA and 401k plans, as
we discussed earlier. Since annual contributions to all IRAs and 401k plans are quite limited,
investment in a low- or no-dividend portfolio may be the efficient shelter for many investors
who wish to exceed the contribution limit. Another advantage of such portfolios is that you
can sell those securities that have lost value to realize capital losses and thereby reduce your
tax bill in any given year. This virtue of risky securities is called the tax-timing option. Man-
aging a portfolio with efficient utilization of the tax-timing option requires expert attention,
however, and may not be appropriate for many savers.
The average dividend yield on the S&P 500 stocks is less than 2%, and other indexes
(such as Nasdaq) bear an even lower yield. This means that you can easily construct a well-
diversified portfolio with a very low dividend yield. Such a portfolio allows you to utilize the
tax advantage of capital gains versus dividends. Spreadsheet 18.9 adapts Spreadsheet 18.6
(progressive tax with no shelter) to a no-dividend portfolio of stocks, maintaining the same
preretirement consumption stream and holding the ROR at 6%. Real retirement consumption,
averaging $47,756, is almost identical to that supported by a Roth IRA (Spreadsheet 18.7).6


Sheltered versus Unsheltered Savings
Suppose your desired level of savings is double the amount allowed in IRAs and 401k (or
403b) plans. At the same time you wish to invest equal amounts in stocks and bonds. Where
should you keep the stocks and where the bonds? You will be surprised to know how many
investors make the costly mistake of holding the stocks in a tax-protected account and the
bonds in an unsheltered account. This is a mistake because most of the return from bonds is
in the form of taxable interest payments, while stocks by their nature already provide some
tax shelter.

6
In Spreadsheet 18.9 we did not take full advantage of the tax code. You can defer capital gains longer by accounting
for the shares you sell so that you sell first new shares with little capital gains and old shares last.
Bodie’Kane’Marcus: VI. Active Investment 18. Taxes, Inflation, and © The McGraw’Hill
Essentials of Investments, Management Investment Strategy Companies, 2003
Fifth Edition




639
18 Taxes, Inflation, and Investment Strategy


Phase Asset Stocks Inside; Bonds Outside Stocks Outside; Bonds Inside
TA B L E 18.3
Savings Bonds Taxed upon accrual No taxes
Investing Roth IRA
Stocks No taxes Taxes deferred
contributions
in stocks and Withdrawal Bonds No taxes No taxes
bonds Stocks No taxes Taxed at capital gains rate




Phase Asset Stocks Inside; Bonds Outside Stocks Outside; Bonds Inside
TA B L E 18.4
Savings Bonds Taxed on accrual Taxes deferred
Investing traditional
Stocks Tax deferred Taxes deferred
IRA or 401k
contributions Withdrawal Bonds No taxes Taxed at marginal rate
in stocks and Stocks Taxed at marginal rate Taxed at capital gains rate
bonds



Recall that tax shelters enhance the retirement annuity with two elements: (1) tax deferral
on contributions and (2) tax deferral on income earned on savings. The effectiveness of each
element depends on the tax rate on withdrawals. Of the two types of tax shelters we analyzed,
traditional IRA and 401k (or 403b) plans contain both elements, while a Roth IRA provides
only the second, but with the advantage that the tax rate on withdrawals is zero. Therefore, we
need to analyze the stock“bond shelter question separately for each type of retirement plan.
Table 18.3 shows the hierarchy of this analysis when a Roth IRA is used. The difference is
apparent by comparing the taxes in each column. With stocks inside and bonds outside the
shelter you pay taxes early and at the ordinary income rate. When you remove stocks from and
move bonds into the shelter you pay taxes later at the lower capital gains rate.
When you use either a traditional IRA or 401k plan, contributions are tax deferred re-
gardless of whether you purchase stocks or bonds, so we need to compare only taxes on
income from savings and withdrawal. Table 18.4 shows the trade-off for a traditional IRA or
401k plan.
The advantage ends up being the same as with the Roth IRA. By removing stocks from and
moving bonds into the shelter you gain the deferral on the bond interest during the savings
phase. During the retirement phase you gain the difference between the ordinary income and
the capital gains rate on the gains from the stocks.


<
8. Does the rationale of sheltering bonds rather than stocks apply to preferred stocks? Concept
CHECK
18.6 SOCIAL SECURITY
Social Security
Social Security (SS) is a cross between a pension and insurance plan. It is quite regressive in
the way it is financed, in that employees pay a proportional (currently 7.65%) tax on gross Federally mandated
wages, with no exemption but with an income cap (currently $89,400). Employers match em- pension plan
ployees™ contributions and pay SS directly.7 established to provide
minimum retirement
benefits to all workers.
7
Absent the SS tax, it is reasonable to assume that the amount contributed by employers would be added to your pre-
tax income, hence your actual contribution is really 15.3%. For this reason, self-employed individuals are required to
contribute 15.3% to SS.

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