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Higher Tax Rates Dont Destroy Benefit of Tax Deferral
April 17, 1997

Higher Tax Rates Dont Destroy Benefit of Tax Deferral

Q. Much financial advice is based on two assumptions: one, that income will decrease at retirement; and, two, that tax laws will stay about as they are now. In my own case, I have retired three times ( I may go back to work just because retiring is so much fun) and have the largest income I have ever enjoyed.

Tax deferral would be a losing proposition. In the second case, tax law is determined by politicians, the majority of whom are lawyers. Neither class enjoys a very savory reputation. To achieve tax deferral one must give up control of his own finances, either absolutely or by large penalties for exercising control of his own property. Of course employer contributions change the picture.

My question: are my children really wise to invest heavily in 401k or other plans who main attraction is tax deferral?

—D.B., Abilene, TX

A. Very interesting point. While it was once quite reasonable to assume a lower tax bracket in retirement, the combination of narrowed brackets and changes in tax law vis-a-vis Social Security benefits and qualified plan withdrawals means that many upper middle income earners are likely to experience virtually no reduction in their tax rates when they retire.

But the assumption of lower tax rates in retirement is just one benefit of tax deferral. The other is that the unpaid taxes accumulate and compound. In essence, your tax deferred account really has two sub-accounts— the after-tax account that you would have if you paid taxes and your accumulated tax liabilities. As long as you only withdraw income, you can enjoy the earning power of your tax liability account. Your retirement income will be higher than it would otherwise be.

How much higher? It depends on the return on your investment and how long you invest. Over any long period, however, the power of compounding will overcome almost any increase in tax rate.

This tax deferral is not restricted to qualified plans or insurance products.

What most people forget is that tax deferral is a key element in virtually all methods of capital accumulation. One of the benefits of investing in common stocks, for instance, is that most of the return on your investment is tax deferred because you dont pay taxes on price appreciation until you sell shares and realize your gain. Then, you are taxed at the capital gains rate, a maximum of 28 percent.

The biggest issue in tax deferred plans isnt future tax rates but the cost of achieving tax deferral.

Q. Our 92 year old father must drain his savings in order to meet living expenses. He now lives in group "assisted living" in Massachusetts at a cost of $3,297 a month, not extravagant for the Boston area. None of this expense is covered by his health care policies because it is not a nursing home. His income from Social Security and company pension totals $1,600 a month. Dads assets currently total about $200,000, with about $55,000 in Treasuries or savings; $90,000 in two mutual funds; and the balance in GM or EDS shares.

Do you recommend any of these assets be sold or shifted or consolidated? Should we reinvest the monthly dividends from the mutual funds instead of using them for monthly expenses?

Our father worked long years at modest salaries and saved more than we expected. He is not happy but he is pretty healthy. It is very possible he will outlive his money since his grandmother lived to be 93 despite being a lifelong hypochondriac. We do not want to change his residence until it is necessary for monetary or health reasons. Can you suggest a plan to make his savings last as long as possible?

—VB in Dallas and KS in Boston

A. There is little danger that he will outlive his money. After all, the annual shortfall is less than $21,000 so the money could be stacked in $20 bills in his closet and still last until he was nearly 103. Add a modest return, like 6 percent, and the money will last nearly 15 years.

In fact, I dont see any need to change much. Id convert the current $55,000 in savings and Treasuries into a 3 year Treasury ladder with $21,000 in each year of the ladder by selling some of his individual stocks. Over the course of the next three years Id sell the remainder of the individual stocks and invest the proceeds in more short term Treasury securities.

Questions about personal finance and investments may be sent to: Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas 75265; or faxed to (214)-977-8776; e-mail to scott@scottburns.com Check the website: "www.scottburns.com." Questions of general interest will be answered in future columns.

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