Roth Plan Advantage Often Ephemeral

13 Sunday Jul 2014

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Qualified Plans, Retirement Planning, Roth IRA, Tax-deferred savings, traditional IRAs

Roth tax-deferred savings vehicles (IRAs and 401Ks) are frequently touted as superior to traditional IRA or 401K savings for young savers, sometimes for the wrong reasons. Both types of vehicles offer tax advantages for retirement saving. Roth contributions are taxed immediately, but they grow tax-free and are completely tax-free at withdrawal. Traditional IRA and 401k contributions (“traditionals”) are tax-deductible, but the contributions and growth are taxed at withdrawal. The key determinant of which type of plan contribution is best at a given time is the tax rate faced today relative to the years of withdrawal. Based on this consideration, the Roth is better (for today’s contribution) if today’s tax rate is lower. If today’s tax rate is higher than during the withdrawal period, the traditional plan is more advantageous.

Comparing the two types of saving vehicles must be done on a basis that is equivalent in terms of post-tax, post-contribution income. For example, suppose an individual with a current annual income of $50,000 desires to set aside 6% of their income in their employer’s Roth 401k. The individual’s marginal tax rate is 15% federal plus 5% state. Therefore, they must part with pre-tax income of $3,750 to generate a net $3,000 plan contribution (ignoring the FICA tax). The individual has a “disposable” income after taxes and saving of $50,000 – $10,000 (taxes) – $3,000 = $37,000. Instead, if the individual contributed $3,750 to a traditional 401k, their disposable income would be exactly the same. (The contribution is tax deductible, but the extra tax savings from the 401k deduction is invested in the plan.) This equivalence in terms of the current disposable income is crucial, because the extra contribution in the traditional plan made possible by the immediate tax deduction serves to offset the Roth’s later tax advantage. Megan McArdle, for whom I have tremendous respect, overlooks this point in a piece about Roths here. Moreover, the number of years of untaxed growth in a Roth does not matter if the traditional vehicle grows as well, contrary to one popular explanation of the Roth’s advantages.

Some Easy Math: The conclusions stated above can be deduced easily from basic equations for future value (FV – for the time of the last contribution) in the presence of proportional taxes:

Net FV(Roth) = Gross Monthly Contrib x FVfactor x (1 – tax rate @ contrib)

Gross FV(Trad) = Gross Monthly Contrib x FVfactor

Net FV(Trad) = Gross Monthly Contrib x FVfactor x (1 – tax rate @ w/drawal)

where FVfactor is a function of the return on savings (naturally assumed to be common to the plans) and the number of months of contributions. Obviously, the two plans are equivalent if the two tax rates are equal. While these equations assume that the plan values are compared at the time of the last contribution, the results are robust to longer or differing patterns of withdrawals, as long as the same gross returns are available to both plans (this statement ignores certain rules for mandatory distributions, discussed later).

Comparing Future Outcomes: The table below shows comparisons of Roth and traditional contributions under various scenarios (click on the “?” icon to view the table). The withdrawals in these examples are structured as fixed monthly payouts (annuities) over 30 years. Returns during “retirement” (4%) are assumed to be lower than during the years of contributions (7%). The two vehicles yield the same ultimate level of benefits if the tax rates are the same during the years of contribution and withdrawal (the first “panel” of four rows in the table). If the current tax rate is lower, the traditional vehicle benefits more from the immediate tax deduction than the Roth gains later via non-taxable withdrawals (the second and third panels). The opposite is true if the current tax rate is higher than during the years of withdrawal (the fourth panel). The rightmost column of the table shows the aggregate value of the government’s tax revenue on a time-valued basis, carried forward (traditional) or discounted (Roth) to the date at which contributions end. It should come as no surprise that the difference in the net value of the two vehicles to the saver is equal to the difference in the government’s take (but of opposite sign). If you expect your tax rate to be lower in retirement, you lose and the government wins if you elect to be taxed early on retirement saving, i.e., the Roth.

Likely Tax Rates? What tax rate assumptions are realistic for most savers? First, current marginal federal and state tax rates should be applied to gross Roth contributions. However, a strong argument can be made that tax rates during the period of withdrawal (traditional) should be lower than during the years of contribution. There are three resaons for this:

1) Retirement incomes tend to be lower than during working years for most savers, which often implies a lower tax bracket.

2) Just as importantly, withdrawals from accumulated savings may not represent marginal income, because they are often taxed across multiple brackets because they represent a substantial portion of retirement income. An average tax rate may be more appropriate for calculating the net benefit of withdrawals from a traditional plan. To some extent, this depends upon how social security benefits are taxed, since those benefits may represent “base income” for purposes of calculating an average tax rate applicable to plan withdrawals. Regardless, it can be argued that taxable withdrawals should be assessed at lower tax rates than taxable contributions.

3) Finally, many retirees choose to spend their post-working years in states with lower or no state income taxes, such as Florida and Texas. This would imply an even greater advantage for traditional plans over Roths.

Despite these considerations, there are many young savers laboring in cubicles who are cheerfully anticipating much higher earning years ahead, even for those distant years of retirement from the corner office. For this group, it is possible that contributions to a Roth make sense, but probably not beyond a certain point in their careers, when their marginal tax rate rises above the likely tax rate they will face in retirement. By then, the Roth option will be foreclosed if their incomes exceed the Roth limits on earnings eligibility. Still, the Roth is probably less likely to pan out as the best choice for most workers currently above the 25% federal tax bracket and many at or below it.

Other Roth Advantages: There may be other potential advantages of Roth savings over traditional tax-deferred plans. One is that Roths give the saver more flexibility over the timing of withdrawals simply because the withdrawals are not taxed as ordinary income. (Early Roth withdrawals are subject to the 10% penalty tax (before age 59½, with exceptions.)) Perhaps more importantly, by taking the tax hit immediately on Roth contributions, with no tax liability on future earnings, a Roth has a more certain tax impact than a traditional plan. It may be comforting to think that one’s tax rate is likely to be low in retirement, but who can say how high tax rates will be in the future, given the sorry state of government finances? Then again, the federal government could one day elect to violate its pledge not to tax Roth withdrawals, or it could even impose a wealth tax with broad applicability to all Roth and traditional plan balances. Death and taxes may be certain, but the integrity of government is not.

Finally, there are no mandatory Roth distributions at any age. This flexibility may be useful to some retirees, since complete deferral of taes beyond age 70½ is impossible on traditional plan assets. In terms of estate planning, the final accumulation of assets in a Roth can be passed along to heirs income tax-free. Therefore, an inherited Roth will have more value than a traditional plan if the heirs are in relatively high tax brackets. This argument is often used in favor of Roth conversions from traditional plans, even for individuals of advanced age. Extending the logic, even if traditional plans had no mandatory distributions, Roths would have an estate planning advantage beyond age 70½ if the heirs are in higher tax brackets than their benefactor. In any case, the traditional option is foreclosed for this purpose, given the mandatory distribution requirement on traditional tax-deferred savings.

Trampling On the Right To Have Others Pay

12 Saturday Jul 2014

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“If it weren’t for state power, the Little Sisters of the Poor would be happily not facilitating the birth-control purchases of its employees; the Barack Obama administration has attempted to force them to do otherwise.” That’s from Megan McArdle in a good piece on the Supreme Court’s Hobby Lobby decision. Here’s more:

The interesting question is why people on the other side view ceasing the coercion as itself coercive while arguing that the original law did not, in fact, force anyone to violate their religious beliefs. …while the religious right views religion as a fundamental, and indeed essential, part of the human experience, the secular left views it as something more like a hobby, so for them it’s as if a major administrative rule was struck down because it unduly burdened model-train enthusiasts.

That’s worth an LOL! Oh yes, it’s coercive if we can’t be permitted to coerce you. As a friend recently quipped, your reproductive decisions might not be your employer’s business, but you make it their business when you ask them to pay for your decisions. The economics of the decisions are secondary to First Amendment rights, as buttressed by the Religious Freedom Restoration Act.

The Hobby Lobby decision was not strictly about contraception, but as to the economics of contraception and whether it pays for itself, as many insist, this post offers some interesting perspectives. The economics are not quite as settled as some would have you believe.

The Parasite In Our Midst

09 Wednesday Jul 2014

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Bureaucracy, crony capitalism, federal bureaucracy, Glenn Reynolds, Public Choice, regulation, rent seeking, Revolving Door

The administrative state is costly in many ways. It not only creates obstacles to economic growth. In promulgating and complying with its dictates, it absorbs vast amounts of resources within both the public and the private sectors. It also provides an avenue through which private elites can curry favor via lucrative contracts and favorable regulatory treatment, often gaining competitive advantages and even monopoly status. The opportunities for graft are legion, of course. The infamous revolving door in and out of government service reinforces the rent seeking potential afforded by this “fourth branch” of government. It is a prime example of the dangers of being governed by men rather than laws. Bureaucrats seem to become self-empowered to make wide-ranging and arbitrary decisions regarding matters not anticipated by any enabling legislation.

In “Bled Dry By The New Class,” Glenn Reynolds offers some insightful remarks regarding the sociological phenomenon that is the administrative state. He provides a telling quote from a frustrated Greek entrepreneur, which should be taken as a warning for us: “I, like thousands of others trying to start businesses, learned that I would be at the mercy of public employees who interpreted the laws so they could profit themselves.”

Bad Wind Has No Payback

04 Friday Jul 2014

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I have often heard greens discuss energy gains associated with alternative energy sources, to the exclusion of other resource costs. The idea of energy gain can be very meaningful. For example, nuclear fusion is only now approaching the point of an energy gain. Of course, making fusion an economic source of energy requires much more efficiency than a simple energy gain. Yet the narrative for certain “green” technologies is that energy gains are all that matters. This thinking is fundamentally flawed, to put it kindly. Here is the full embodiment of the idea, as described by Anthony Watts:

US researchers have carried out an environmental lifecycle assessment of 2-megawatt wind turbines mooted for a large wind farm in the US Pacific Northwest. Writing in the International Journal of Sustainable Manufacturing, they conclude that in terms of cumulative energy payback, or the time to produce the amount of energy required of production and installation, a wind turbine with a working life of 20 years will offer a net benefit within five to eight months of being brought online.

The reaction at Coyoteblog is amusing. As noted there, the total resource costs of manufacturing and installing the energy production and distribution facilities are just as real in any “green” sense as the energy expended. This is to say nothing of some of the other shortfalls in assumptions mentioned at the link, as well as the avian death toll. The “payback” measure used by the wind farm researchers constitutes naivete at best and propaganda in pursuit of rents at worst.

I’m convinced that the environmentally-concerned public has the best intentions, but there is a deep misunderstanding at play: the notion that the state must intervene to facilitate the adoption of “sustainable” technologies, never mind that these technologies often require massive subsidies to be economically viable. A nice quote on this point from Coyoteblog:

Environmentalists seem to all feel that capitalism is the enemy of sustainability, but in fact capitalism is the greatest system to promote sustainability that has ever been devised. Every single resource has a price that reflects its relative scarcity as compared to demand. Scarcer resources have higher prices that automatically promote conservation and seeking of substitutes. So an analysis of an investment’s ability to return its cost is in effect a sustainability analysis.

The Jobs Report: All Part-Time; Full-Time Down Half-a-Mil

04 Friday Jul 2014

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There were many breathless reports about today’s release of employment data for June, including this bit of coverage from Forbes. The report was better than expected in many ways: the number of jobs created was fairly strong; there were positive revisions to prior months; the official unemployment rate fell, as did the total “U-6” unemployment rate, which includes the unemployed plus potential workers “marginally attached” to job search and those employed part-time for economic reasons; labor force participation held steady, which must be viewed positively given recent trends.

The report seemed to reinforce impressions that the economy is gaining momentum, a welcome relief after the decline in real GDP in the first quarter. Some referred to June as a possible “inflection point,” but that obviously remains to be seen. Labor market conditions have been less than robust, the unemployment rate is still high for this stage of an economic expansion, and there are still far too many long-term unemployed and discouraged workers.

In addition, very little attention was paid by the media and most economists to a disturbing pattern in the jobs created in June: While total employment increased, there were 523,000 fewer full-time jobs (seasonally adjusted), while part-time employment increased 799,000. ZeroHedge has a brief discussion with a few charts. This undermines the case for real strength. There are fears that more full-time workers will be reduced to part-time status as the (delayed) Obamacare employer mandate takes hold in 2015. The chart above does not include the data for June: 80.8% full-time and 19.2% part-time, so the gap widened.

Redistributing a “Progressively” Smaller Pie

03 Thursday Jul 2014

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bailout, Casey Mulligan, Disincentives, Redistribution, Welfare State

“A Recovery Stymied By Redistribution” contains excerpts from a recent speech by Casey Mulligan of the University of Chicago. It’s about the destructive power of bad incentives, and it reeks of common sense. It’s long been recognized that efforts to soften economic blows can have damaging incentive effects. Today, those well-intentioned efforts have been expanded beyond the point at which they become counterproductive, and the negative effects are being compounded by new programs that can act as taxes on work effort.

I’ve witnessed some of the phenomena Mulligan describes first-hand. There is no question that some people can be tempted to accept benefits in exchange for a less than vigorous job-search effort, sometimes for no search effort at all, and sometimes fraudulently when they already have gainful employment. Mulligan quotes a job recruiter who, during the recession, “ran into a hurdle he hadn’t seen before. People would apply for jobs not with the intention of accepting it, but to demonstrate to the unemployment office that they were looking for work.” Mulligan also describes ways in which employers have seen reductions in their incentives to retain marginal workers.

Some programs are better than others at minimizing disincentives created by assistance. But here is what Ben Franklin thought:

I am for doing good to the poor, but I differ in opinion of the means. I think the best way of doing good to the poor, is not making them easy in poverty, but leading or driving them out of it. In my youth I traveled much, and I observed in different countries, that the more public provisions were made for the poor, the less they provided for themselves, and of course became poorer. And, on the contrary, the less was done for them, the more they did for themselves, and became richer.

— On the Price of Corn and Management of the Poor, November 1766

Damaging disincentives are also created by efforts to ease economic blows to businesses. Corporate bailouts, for example, create perverse, one-sided “win-can’t lose” sets of outcomes, leading to taxpayer subsidies and excessive risk-taking.

Time For OTC Contraceptives

02 Wednesday Jul 2014

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Contraceptives, Hobby Lobby, Obamacare, OTC, Prescription Drugs, Small Government, Vox

Here are seven reasons birth control pills shouldn’t require a prescription, offered by Adrianna McIntyre in Vox. There is much concern over “access” to contraceptives in the wake of the Hobby Lobby decision. While any new concern is largely misplaced, the biggest impediments to access might well be the prescription status of these drugs and their cost. Making contraceptives available over-the-counter would do a great deal to reduce these problems while leaving everyone else with a clear conscience. In fact, it would greatly improve access for the uninsured, a group which will remain large despite the best intentions of Obamacare supporters. As the Vox article notes, physicians support the move to make contraceptives available OTC, and it is highly feasible politically, though support will be contingent on certain safeguards, such as restrictions on sales to minors. Otherwise, it is a classic “small government” solution.

Abortifacients and Hobby Lobby

01 Tuesday Jul 2014

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Abortifacients, ACA, Contraception Mandate, Corporate Form, Hobby Lobby, Obamacare, Supreme Court

Some are apparently too lazy, propagandized or ignorant to understand the facts underlying the Supreme Court’s Hobby Lobby decision. But not too lazy to re-tweet or re-post unreliable information.

Here is what the decision means:

1) The decision was narrower than the sloppy memes and some media reports would have you believe. Of the 20 different contraceptives approved for use by the FDA, only four are affected by the decision. Hobby Lobby offers the other 16 through its employee health plan, and it will continue to offer them. The four it is no longer required to offer through its plan are so-called abortifacients, which destroy an already fertilized egg. The ruling does not imply that Hobby Lobby can avoid covering other “mandated benefits” under Obamacare, including the other 16 contraceptives. (In my view, however, the entire coverage mandate should be struck down as well, keeping employer-provided health care benefits a private contactual matter. The specifics of the mandate were not part of the ACA legislation. They were promulgated by bureaucrats at HHS for whom overreach has no meaning.)

2) In general, when individuals decide to associate or act under a corporate form, the corporation assumes the rights they possess as individuals. Human action taken under the corporate form does not involve a diminution of individual rights. Yet the left acts as if people have no rights when acting under the corporate form. Incorrect. Speech, religion — all rights that are granted to individuals under the Constitution are guaranteed to them whether they act as a corporate association or not.

3) The decision in Hobby Lobby applies only to closely-held corporations, the shares of which are not publicly traded. These are not the “faceless corporations” of popular infamy, but are often family-owned companies, associations of partners, or professional practices. Publicly-traded corporations are not affected by the ruling. Only privately-held corporations with more than 50 employees (under the original provisions of the ACA) are affected.

4) The decision does NOT interfere with womens’ rights to obtain most contraceptives. It means that the government cannot force Hobby Lobby to pay for abortifacients, and female employees have an unrestricted right to pay for abortifacients out of their own pockets. They are employed, after all. In addition, the ruling has nothing to do with coverage of abortion procedures that might be necessary when a mother’s life is at risk.

5) The government is not restricted, except as a possible matter of politics, from offering all women free access to abortifacients. It has not offered to do so, however. Therefore, under the 1993 Religious Freedom Restoration Act (RFRA), signed by President Clinton, the Court held that the government cannot impose any burden on private parties (including individuals organized as closely-held corporations) in violation of their religious beliefs if there is a less burdensome alternative available. The RFRA’s importance to the Hobby Lobby ruling is discussed here.

6) Some have accused Hobby Lobby’s owners of hypocrisy, since they sell goods imported from China, where abortion is often coerced by the state. And that might be hypocritical, but the only possible relevance to the case would be if the purchase of Chinese goods reflected on the sincerity of their religious beliefs. That is a litmus test that few would sanction. A beauty of private markets is that they tend to be impersonal, allowing individuals of different cultural practices and beliefs to trade peacefully with one another if they so desire. That has no bearing on the type of labor contract that Hobby Lobby may offer its own employees. In any case, the ruling applies more broadly than to Christian importers of Chinese goods.

Aside

Just Insurance? Or Unjust Insurance?

29 Sunday Jun 2014

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ACA, adverse selection, central planning, Obamacare, Risk Ratings

Voices from the left keep insisting that universal coverage and a single, all-inclusive risk pool is “just insurance,” and that anyone standing in opposition just “doesn’t understand insurance.” The argument is usually extended to the idea that all individuals must receive and pay for a comprehensive set of benefits, going far beyond any reasonable notion of catastrophic coverage. Proponents of this view advocate an extreme form of socialized health coverage that eliminates private choice and traditional risk-rating.

In a free society, individuals cannot be coerced into cross-subsidizing activities that might violate their religious convictions. It is hoped that this will be affirmed by the Supreme Court’s Hobby Lobby decision, likely to be issued this Monday.

Likewise, in a free society, individuals should not be forced to cross-subsidize private choices made by others. Preserving the right of individuals to purchase the benefits and coverage levels of their choice at reasonable premia (e.g., catastrophic care only or “wellness” features, no pregnancy coverage for senior citizens, risk-based pricing) is crucial. Providing care for high-risk individuals with pre-existing conditions need not involve a dismantling of the private health insurance market.

Of course, Obamacare has fallen short of the socialist “ideal,” either before or after all of the exceptions, delays, and waivers made by the administration and HHS. Its design, nevertheless, has had a destructive impact on the private insurance market, and the program is straining under the effort to provide high-risk coverage. In “Obamacare’s Prognosis Grows Dimmer,” Lanhee Chen discusses how adverse selection is playing out on the Obamacare exchanges. Based on the evidence available thus far, the exchanges appear to be laden with a high percentage of sick individuals. This is likely to lead to more premium shock for enrollees as we head into the mid-term elections.

A path toward providing effective coverage for pre-existing conditions is discussed in this article. It asserts that a solution hinges on the ability for individuals to make seamless transitions between employer-provided coverage and individual coverage, even with pre-existing conditions. Since that ability must apply nationwide, the authors also assert that there must be a role for federal funding of the high-risk pool of individuals making the transition to the individual market.