ARGENTUS OUTLOOK
THE
INVESTMENT SOLUTIONS THAT FIT TODAY’S GLOBAL ECONOMY
Should Investors Delay the Tax Bite?
March 2014 • Volume 3, Issue 3
By W. Michael Cox and Richard Alm Small Talk Uncle Sam sometimes gives taxpayers a choice: Pay • Bankrupt nation. Boston University me now or pay me later. Investors can sock away a
To learn more about deciding whether economist Laurence Kotlikoff estimates to defer taxes, use our calculator: portion of their savings in tax-deferred investment America’s true national debt at $205 trillion. http://argentusoutlook-66096.hibustudio.com/newsletter/1238573 vehicles—traditional IRAs, Roth IRAs, 401ks, 403bs, He starts with the $12 trillion in existing debt $1,000 would grow when sheltered from taxes—if he in the hands of the public. Then he adds up all Simplified Employee Pension (SEP) plans, Keoghs, fixed the future obligations to pay for Social faces lower tax rates in retirement. After 41 years— and variable annuities and the like. Security benefits, Medicare, Medicaid and the Smith will be 67—he’d have $17,597 after taxes if Financial advisors usually urge clients to take routine functions of government. Projected tax he anticipates an income tax rate of 25 percent in advantage of these tax breaks, often to the max. revenues fall 60 percent short, leaving the retirement (see chart below ). Delaying taxes is usually a good deal. Just how good nation $205 trillion in the hole. The government Smith worries about the federal government’s huge depends on investment returns, current tax rates, disguises this massive debt with accounting fraud far worse than anything perpetrated by fiscal deficits and unfunded promises. Future taxes may anticipated future tax rates and years until retirement. Bernie Madoff or Enron. “So the country really is be higher, not lower, especially for wealthy Americans. If To show how these factors interact, we conjure bankrupt and nobody sees it because of the Smith continues to pay taxes at a 40 percent marginal up a 21st Century Adam Smith. He’s 26 years old, a bookkeeping,” Kotlikoff said. rate into his retirement, his after-tax gain would be Harvard-educated lawyer earning enough to put him in • Regulatory beat. Using the Internet to help reduced to $14,077. the top tax bracket. Smith needs to decide whether to startups raise capital, equity crowdfunding How does this compare with a scenario where Smith defer taxes on his retirement savings. gives small investors a chance to get in on pays taxes on his savings every year? The tax bite starts Tax Rates, Returns and Time the ground floor of what might be the Next with his current income at 40 percent, reducing his Smith projects an annual return of 8 percent—close Big Thing. The Securities and Exchange initial investment to $600. to the long-term average for U.S. stocks. Facing a Commission proposes to limit the size of investments, mandate specific disclosures Each year, he’d pay the taxes due on his investment marginal tax rate of 40 percent, each $1,000 he puts in and require SEC-registered intermediaries.To income—40 percent if earned as interest or nona tax-deferred account would save him $400 in current raise between $500,000 and $1 million, fees qualified dividends, a 20 percent base plus 3.8 percent taxes but create future tax liabilities. and compliance costs would range from Medicare surcharge if earned as qualified dividends Smith wants to see how the after-tax value of $76,660 to $151,660. “The SEC must avoid costly, paternalistic requirements on Continued on page 2 crowdfunding that have the effect of keeping the status quo and locking ordinary investors Longer Time Horizons, Lower Taxes Magnify Gains from Deferring Taxes out of startup capital,” said John Berlau, senior fellow for the Competitive Enterprise Institute. $18,000
• Borrowing again. The financial crisis battered American households and left them leery of debt. According to the Federal Reserve Bank of New York, total household debt peaked at nearly $12.7 trillion in the third quarter 2008. In subsequent quarters, Americans owed less than they did a year earlier—a pattern that held for the next five years. Now, the great deleveraging has ended—at least temporarily. With households willing to buy cars and houses and use their credit cards, debt surged $241 billion in last three months of 2013, creating a four-quarter increase of $180 billion in outstanding debt. Total household debt was $11.5 trillion. Fed Watch and Chart Topper: Page 3
$17,597 Defer Taxes
$16,000 Pay as You Go $14,077
$14,000 25% Tax Rate in Retirement $12,000
40% Tax Rate in Retirement
$10,000
$8,904 $8,000 15% Tax Rate $6,789 on Capital Gains $6,000 23.8% Tax Rate on Capital Gains $4,000 Initial Investment of $1,000, 8% Annual Rate of Return
$2,000 $0
0
5
10
15
20
25
After-Tax Value at the End of N Years
30
35
40
Source: Authors’ calculations
THE ARGENTUS OUTLOOK Continued from page 1
or capital gains. At 23.8 percent, the after-tax value of Smith’s $600 would be $6,789 at the end of 41 years—a bad deal compared to the tax-deferred plan. Until 2013, the tax rate on long-term capital gains and qualified dividends was 15 percent. At 41 years, raising the tax rate to 23.8 percent reduced the after-tax value of each $1,000 from $8,904 to $6,789. For each $1,000 held 41 years, not deferring taxes cost Smith $10,808 at the 25 percent tax rate and $7,288 at the 40 percent tax rate. A quick calculation reveals Smith’s average annual after-tax returns—7.25 percent for the taxdeferred account, 4.78 percent for the pay-now approach. To Defer or Not Defer No fool with money, Smith decides to put his savings into a tax-deferred account—not just that first $1,000 but many additional $1,000s, every year throughout his legal career. He expects to retire with a nest egg of millions of dollars. The exercise taught Smith some valuable lessons. The payoff from delaying the tax bite will increase with higher tax rates on current income, lower tax rates on retirement income or higher investment returns. Perhaps most important, Smith came to appreciate the miracle of compound interest—the great value of time in reaping rewards from tax-deferred investing. At a 25 percent tax rate in retirement, the gap between deferring taxes and paying 23.8 percent each year widened with each passing decade—$535 at 10 years, $1,536 at 20 years, $4,006 at 30 years and $10,808 at 41 years. Can our Adam Smith ever find it better to pay taxes now rather than delay them? It’s not likely on wage and salary income facing the top marginal rate—the initial tax hit’s just too big. The answer’s different if the initial funds come not from income but from assets not
burdened by tax liability. If Smith’s considering shelter these assets’ future gains through a tax-deferred plan, he’ll face a tradeoff between the pay-now tax rate and his time horizon (see chart below ). Shorter time horizons and lower tax rates favor paying taxes every year (orange area ). The decision shifts toward deferring taxes when money has more years to grow and capital gains taxes go up (green area ). At various combinations of tax rates and years, the choice between paying Uncle Sam now or later would be a coin flip—if Smith’s annual rate of return stays at 8 percent (arced line ). Now, Smith can see another impact of the recent hike in the long-term capital gains tax. At the 15 percent rate, it took 19 years for deferring taxes to gain an edge over paying annually. Now that he’s taxed at 23.8 percent, deferring taxes will start to pay off in just two and a half years. A final thought. Most portfolios include a variety of financial assets—stocks, bonds, mutual funds, etc. For tax purposes, some holdings are short term and taxed as regular income at 40 percent, some are long term and taxed as qualified dividends and capital gains at 23.8 percent. This complicates the calculation of an investment tax rate. Suppose Smith holds only growth stocks that pay no dividends and takes his gains every 10 years, paying taxes at 23.8 percent. His equivalent annual tax rate would be 18.3 percent. Now, suppose Smith derives his investment income in equal thirds from interest, dividends and capital gains. Half of the dividends and capital gains are short term, facing the 40 percent rate. His equivalent annual tax rate would be 33.8 percent.
With Higher Capital Gains Taxes, Deferring Money Makes More Sense 30%
Capital Gains Tax Rate
At an 8% rate of return and a capital gains tax rate of 23.8%, you’re better off investing inside a tax-deferred plan if your time horizon exceeds 2½ years.
25%
20% Better Off Being in a Tax-Deferred Investment Plan 15%
At an 8% rate of return and capital gains tax rate of 15%, you’re better off paying taxes as you go if your time horizon is less than 19 years.
10%
Better Off Paying Taxes As You Go
5%
0%
0
5
10
15
20 Years of Tax Deferment
25
30
35
40
What It Means for Your Clients By breaking down the influences of investment returns, today’s tax rates, tomorrow’s tax rates and investment time horizons, Dr. Cox adds some important nuances to decisions about tax-deferred investing. For example, it will pay off even if your clients don’t face lower tax rates in their retirement years. That’s good to know. It’s no longer safe to assume that the U.S. government won’t raise tax rates in the future—with wealthy households the likely target for tax hikes. Another important conclusion: the case for putting off taxes has become even stronger now that the government no longer taxes qualified dividends and capital gains at just 15 percent. Once again, that’s good to know. By April 15, many of your clients will be filing their first federal income tax returns subject to the 23.8 percent rate. For the most part, tax-deferred investing has been synonymous with 401k plans and similar accounts. Not all your clients will have the option of saving in a 401k; others’ saving needs may exceed the annual limits on 401k contributions. The financial industry offers a variety of ways to meet their needs. For example, your clients might consider putting aftertax money into fixed or variable annuities that delay the tax bite. Today’s higher capital gains tax rates may make investors more receptive to this option. Among fixed annuities, indexed products are better than traditional ones in today’s market, where interest rates have nowhere to go but up. In some cases, annuity balances are protected from the claims of creditors, another advantage over other forms of savings. By Argentus Partners, LLC
Source: Authors’ calculations
About Michael Cox
Richard Alm
W. Michael Cox is director of the William J. O’Neil Center for Global Markets and Freedom at Southern Methodist University’s Cox School of Business. He is chief economic advisor to Argentus Partners, LLC.
Richard Alm is writer in residence at the William J. O’Neil Center for Global Markets and Freedom at Southern Methodist University’s Cox School of Business
THE ARGENTUS OUTLOOK
W. Michael Cox’s Fed Watch: For years now, the Federal Reserve has tried to fuel growth and reduce unemployment by keeping interest rates low and pumping money into the economy through securities purchases. The policies haven’t delivered as promised, largely because banks chose to hold excess reserves rather than make loans. You could say shame on the banks—but the Fed brought this upon itself. It made four policy mistakes that contributed to the banks’ hunkering down. First, the Fed started paying interest on reserves. Lending offers low interest rates and high risks. Holding reserves allows banks to make low returns without taking any risks. Second, the Fed heaped on added bank regulation, often taking its sweet time. The new rules raised costs of lending, and the delays created uncertainty in an
already wary financial services industry. Third, driving interest rates down contributed to a “liquidity trap,” sapping the effectiveness of traditional monetary policy tools. In the trap, interest rates can’t go any lower, and lenders hang back and wait for them to rise back to normal levels. Fourth, the Fed helped big banks get bigger. While small banks were allowed to fail in the financial crisis, government policy protected the biggest banks through bailouts and mergers. The four largest banks now have 41 percent of depository industry assets, up from 38 percent in 2007. When big banks gobble up more assets, small business lending suffers, depriving the economy of a spark (see Chart Topper below ). Early on, the economy didn’t respond to the flood of money, but the Fed failed to see the error of its ways. It
just kept making the same mistakes again and again, culminating in the $85 billion a month in quantitative easing during 2012 and 2013. Even today, the Fed persists in these policies. It would be bad enough if the Fed’s misguided policies merely held back economic activity and job growth. But they created an even bigger potential problem, one that will haunt the central bank this year and beyond. The policies of the past five years have left the banking system awash in excess reserves, greatly increasing the risks of higher inflation and interest rates. In 25 years at the Federal Reserve Bank of Dallas, Dr. Cox rose to chief economist and senior vice president, advising the bank’s president on monetary policy and other economic issues.
Chart Topper Too Big to Lend Small: Largest Banks Could Be Doing More for Small Businesses Small businesses borrow for a variety of reasons—to invest in new facilities, modernize equipment, buy inputs, raise working capital, refinance debt. More often than not, they turn to small business loans, a category covering transactions up to $1 million. At America’s biggest banks, the reception has been chilly. The four largest banks—JP Morgan Chase, CitiBank, Bank of America and Wells Fargo—have 41 percent of all depository industry assets but make just 21 percent of small business loans. Most of the credit that fuels small businesses’ expansion comes from the nation’s 6,000-plus smaller financial institutions, notably the American Express bank. Rather than lending to small businesses, the banking behemoths are concentrating on other financial services, presumably ones they find more profitable. Since the financial crisis in 2008, for example, the biggest banks credit-card operations have been surging. Fearing big bank failures would cripple the economy, policy-makers doled out billions in government aid during the financial crisis. Critics gave these banks a disparaging moniker—Too Big To Fail. By not making their share of small business loans, the giant financial institutions may also be Too Big to Lend Small.
100
Percent of Small Business Loans
Share of Small Business Loans Equals Share of Assets Along Diagonal Line
90 80 70 60 50
American Express, FSB
40 30 20
Wells Fargo Bank of America
10 0
CitiBank JPMorgan Chase 0
10
20
30
40 50 60 Percent of All Depository Industry Assets
70
80
90
About The Argentus Outlook A monthly publication of Argentus Partners, LLC, the newsletter strives to deliver current economic information relevant to investing and operating in today’s complex global economy.
100
Source: Federal Deposit Insurance Corp.
Chief Executive Officer: Douglas Gill, CFP® Publisher: Susanna Joiner, Chief Marketing Officer Editor: Richard Alm Contact: marketing@argentuspartners.com
THE ARGENTUS OUTLOOK
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Important Disclosures: Information herein in this newsletter and has been obtained from sources believed to be reliable, but its accuracy and completeness cannot be guaranteed. This newsletter is for informational purposes only, and should not be considered as an offer, invitation or solicitation to subscribe, purchase or sell or any securities, and is not intended to provide any specific investment advice or recommendation. You should review your personal financial situation, investment objectives, goals and risk tolerance prior to investing. All indices referenced are unmanaged and an investor cannot invest directly into any index. The economic forecasts and projections illustrated in the newsletter may not develop as predicted and there can be no guarantee or assurance that strategies promoted will be successful. All expressions of opinion reflect the judgment of Dr. Cox and his research conducted for Argentus Partners, LLC at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. This research material has been prepared by Argentus Partners, LLC. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that Argentus Partners, LLC is not an affiliate of and makes no representation with respect to such entity.