An Economic Perspective From A CPA/Economist
-By Drake Williams, Ph. D., CPA
Many people, including business owners, admit to uneasy relationships with the Internal Revenue Service and its daunting system of taxation. And, moreover, fully admit to difficulties in understanding the role that taxes can play in creating wealth because they do not fully comprehend the importance of tax incentives.
As a result, many choose an accountant to calculate their taxes in accordance with the tax code, at least as they understand it, in hopes of minimal interference in their businesses from the IRS. For this group, the end-of-the-year tax duty begins with the annual trek to a tax preparer, whose typical input may include use of different write-offs or other year-end deterrents to lower the amount of taxes due.
However, these year-end marginal number crunching exercises are defensive in nature because they deal with what has already transpired in the life of a business, effectively shutting the gate after the horses have escaped. This practice is not meant to help a business owner achieve the life goals that he or she has set. In fact, these devices may divert energy and attention away from long-term planning for wealth creation. For that, we must turn to the available tax incentives, which requires setting one’s sights on the future.
The “wealth approach” to tax planning, in contrast, is more like a long-term economics project. For this path, we identify those tax provisions that best serve our financial goals and well-being. Then we implement them to create an economic chain of events that compounds wealth, tax free.
The Path Forward
Consider the hypothetical case of 50-year-old attorney Evie Arditti. She’s raising two children as a single parent, works hard and has a burgeoning practice. Within ten years, she imagines a secure, independent retirement with an oceanfront view.
Yet like so many of us, she faces serious impediments to her well-earned dream. She worries about funding her retirement account, about paying for escalating healthcare costs as she ages, and about her ability to contribute to her teen-aged children’s education fund. For the last few years, Ms. Arditti has paid an average $36,000 in federal taxes annually, and wonders if the money could have been better spent to support her personal objectives.
There are a variety of tax-qualified retirement plans that allow participants to set up a personal account to which tax-free contributions may be made to finance life after employment.
A popular type is the 401 (k) “contribution” plan. But the tax deductions and maximum possible savings in such plans are limited in several ways. The Maximum Annual “Addition” (the largest tax-deductible deposit to an individual’s account) is $54,000 each year, but no more than 100% of that individual’s compensation.
While a reliable vehicle to economic security in the golden years, the Maximum Annual Addition rules mean Ms. Arditti can only build up about half a million dollars of contributions, plus earnings, in her account. And the maximum “deduction” Ms. Arditti can take for contributions is 25% of her compensation. So, she must receive compensation of $216,000 to allow her to contribute $54,000. It is a severe restriction to Ms. Arditti’s ability to retire within her desired time frame.
To allow for a much larger contribution, a Defined Benefit Plan provides a pension – a monthly benefit payment for the life of the participant commencing at the Normal Retirement Age (NRA) defined in the plan, which could increase Ms. Arditti’s retirement advantage to a maximum of $215,000 annually — or to a lump sum equivalent benefit of $2.6 million. Compared to the 401(K) limitations, you can see the advantage.
Nothing gives rise to fears of aging like the specter of unforeseen healthcare costs. A Health Savings Account, or HSA, is an avenue to mitigate these concerns. Not only does it help pay for medical costs not covered by insurance, it provides a triple tax advantage:
• HSA owners get a tax break on the money they contribute to the account;
• The contents of the account are exempt from taxes; and
• Money taken out to pay qualified medical expenses is not taxed.
In our hypothetical case, the IRS limits the amount that Ms. Arditti’s can contribute for family coverage to $6,900 per year.
To address the daunting costs of higher education, Ms. Arditti is considering an IRS 529 savings account to defray tuition, books and other education-related expenses. Although contributions to this account are not tax deductible, the earnings grow tax-free, and they would not be taxed when the funds are taken out.
Under the 529 plan, Ms. Arditti could contribute up to $75,000 per year, per child, without being subject to the federal gift tax. Family members and friends could make gifts to her plan as well.
The Wealth Creation Model
Within the framework of economic theory, these plans create an exponential wealth effect based on the time value of money, and tax-free compounding.
Let’s assume Ms. Arditti is in the 32% tax bracket, and to avoid the 401(K) limitations, adopts a defined “benefit” plan to retire within her desired time frame. Given investment opportunities, she thinks she can earn 10% per annum tax-free (a tax-equivalent yield of 14.706%).
Also, Ms. Arditti can contribute up to $80,000 per year to her retirement plan for ten years. If she does, the “tax savings” alone will accumulate $242,395. And the higher her marginal tax bracket (state and federal), the higher the tax-equivalent yield and wealth effect.
After retirement at age 60, Ms. Arditti anticipates living 25 more years (of course, she’s going to live longer, and I wish her good health), and plans to withdraw $125,000 annually from her retirement account. Of course, the draw-down balances will continue to earn 10 percent.
So, how much should Ms. Arditti “actually” deposit annually to retire with $125,000 per year for the next 25-years (leaving a goose egg for heirs)? Answer: 10 annual contributions of $61,228.
Wait! How can 10 annual payments of $61,228 deliver 25 annual payments of $125,000? It’s called the power of compounding interest. Over her lifetime compounding interest will add $2.45 million tax-free to her retirement account for a total of $3.125 million after adding in her annual contributions.
Next Ms. Arditti intends to transfer 10-annual payments of $6,900 from her taxable savings account into a non-taxable HSA account to meet the spectra of unforeseen healthcare costs.
And finally, to address the daunting costs of higher education, Ms. Arditti contributes todady $100,000 to an IRS 529 educational plan.
Let’s review: Ms. Arditti choose to contribute $80,000 annually to her Pension plan; $6,900 annually to her Health care plan; and made a one-time deposit of $100,000 to her Tuition plan. After 10 years, these plans accumulated $1.830 million, or $327,000 more in a tax-free account than in a taxable account. From age of 50 through 85, after paying out $3.125 in retirement benefits and $178,000 in health care and tuition costs, the tax incentives provided $1.76 million dollars more than a taxable account.
The primary focus of the economic model is the yellow line – the amount building up tax free to apply towards retirement, health care, and education costs. The secondary focus is how it trends commensurate with her life span (35 years).
Of course, a tax payer’s gross earnings are the major driver. But regardless of one’s tax bracket, the theory is the same: develop and support the taxpayer in a business and family context and expand and improve the taxpayer’s wealth and quality of life instead of simply relying on yearend number crunching exercises.
Drake Williams is a practicing CPA with a Ph.D. from the London School of Economics.