Gyroscopic Investing

moda0306 wrote: They'd move to Fair Tax Compliance instead of Income Tax Compliance.  Accountants are spending a HUGE amount of time on state-by-state sales tax analysese.  It's not all that simple.  Heck, a flat income tax would still have questions as to "what constitutes income," just as sales tax would have the question "what constitutes a taxable sale."

I guarantee you it's really not "simple," and probably not all that "fair."

I tend to think that a lot of what complicates the tax code is simply the fact that our lives & contracts are complicated, and the tax code has to decide what constitutes "income" or a taxable event.

I'm sure you're right, but then at least we/they would only have to do that for sales tax rather than for sales tax, income tax, capital gains tax, corporate tax, inheritance tax, AMT et, right? I'm not a huge fan either, but the question I really need to ask myself is, "do I dislike the FairTax more or less than the current mess?" I think I dislike the current mess more, although I might change my tune if the FairTax is ever implemented of course (unlikely).

The current mess isn't ideal by any means, but our system is set up to deal with it.  I hardly think completely up-ending the system to deal with something almost as complicated when there are ways to significantly simplify our income tax without causing much of a structural uproar is much easier.

moda0306 wrote: […] there are ways to significantly simplify our income tax without causing much of a structural uproar

I'd love to hear your thoughts on this.

PS,

First, get rid of AMT and most deductions and lower the tax rates, get rid of preferred tax rates on different kinds of income.  Have some base exemption before said tax kicks in, probably similar to how it works today.  Progressive rates are ok... this is rarely where complications arise.  Some kind of allowance for inflation on capital gains held over 5 years or so might be appropriate, as would inflation-adjusting tax on interest/dividends (though I am saying this as a comment on the morality of the system... it would almost definitely be easier to simply have no adjustment for inflation).  Get rid of a lot of the phase-ins and phase-outs of tax preferences that make people spend tons of time trying to game what ever effective marginal tax bracket they're in.  Lower FICA & Medicare taxes and apply them, as well, to all forms of income.  Lower-if-not-eliminiate the tax on C-Corps, but remove some of the asinine monopolistic benefits they receive.

Try to create some uniformity in all the retirement accounts, which are a mad-house right now... which brings me to the one area where I think there SHOULD be deductions... in financial decisions people don't like to make but will if they can deduct it because we're odd animals and hate government more than we hate saving or insurance .

I think the first $2,000-or-so in premium of any life, health, long-term care, and long-term disability insurance policy should be deductible, with the benefits paid tax-free.  Also, any retirement contributions, though in a more unified manor, should have tax-preferences attached.  I also think the first $1,000 of interest income should be non-taxable.  This will get people achieving a savings cushion more often.  These are areas where I simply feel that we have a motivating mechanism (the tax code, and the fact that people hate taxes), to help be a catalyst to smart financial decisions without being a complex nightmare.

One area that will remain complicated no matter what is the grey area between personal and business expenses.  This is going to always suck.  I have no idea how to thread the needle in a proper way through this topic, though I think it's currently too complex.

moda0306 wrote: PS,

First, get rid of AMT and most deductions and lower the tax rates, get rid of preferred tax rates on different kinds of income.  Have some base exemption before said tax kicks in, probably similar to how it works today.  Progressive rates are ok... this is rarely where complications arise.  Some kind of allowance for inflation on capital gains held over 5 years or so might be appropriate, as would inflation-adjusting tax on interest/dividends (though I am saying this as a comment on the morality of the system... it would almost definitely be easier to simply have no adjustment for inflation).  Get rid of a lot of the phase-ins and phase-outs of tax preferences that make people spend tons of time trying to game what ever effective marginal tax bracket they're in.  Lower FICA & Medicare taxes and apply them, as well, to all forms of income.  Lower-if-not-eliminiate the tax on C-Corps, but remove some of the asinine monopolistic benefits they receive.

Try to create some uniformity in all the retirement accounts, which are a mad-house right now... which brings me to the one area where I think there SHOULD be deductions... in financial decisions people don't like to make but will if they can deduct it because we're odd animals and hate government more than we hate saving or insurance .

I think the first $2,000-or-so in premium of any life, health, long-term care, and long-term disability insurance policy should be deductible, with the benefits paid tax-free.  Also, any retirement contributions, though in a more unified manor, should have tax-preferences attached.  I also think the first $1,000 of interest income should be non-taxable.  This will get people achieving a savings cushion more often.  These are areas where I simply feel that we have a motivating mechanism (the tax code, and the fact that people hate taxes), to help be a catalyst to smart financial decisions without being a complex nightmare.

Moda, I'd vote for you any day of the week.

What about also introducing a national sales tax, to at least start the shift away from taxing income (productive work) and toward taxing consumption?  That's not a new idea.

sophie,

This seems to be a good spot to mention that I really abide by the Cullen Roche (of MMR fame) school on supply/demand.  Investment requires demand for the productive output that the investment is built to produce.  Investment requires demand.  So as much as I dislike consumerism, I realize that idle minds/hands are a lot worse, and we are in a DEMAND-based recession (caps are for emphasis, not condescention (if that's even a word)).  We can slash taxes and regulations all we want, but we're not in a confidence recession where factory's aren't being built because businesses are scared of taxes and regulations... demand, or the lack thereof, is the driver of our current recession.  If we're at 70-80% of productive capacity, Eddie Entrepreneur (in aggregate) is simply not going to invest in a new factory.

So after all that, no, I don't see a reason to tax consumption vs production.  To be pro-production and anti-consumption, simultaneously, is simply oxymoronic.  I think both are two sides of the same econo-equilbrium coin.  Today would probably, in fact, be the worst possible time to switch to a consumption-based tax.

sophie wrote: Actually, if you go back and do the numbers assuming a higher tax bracket post-retirement, up to 40% even, the 401K still wins.  In reality, the rates would be graduated and you wouldn't pay that on the entire amount.

No, I didn't say "bracket".  I said "rate" and I meant "rate".

The math and the facts are trivial.

If you assume a lower tax rate when it comes out of the 401(k), the 401(k) will win.  If you assume a higher tax rate it will lose.  The same tax rate will tie.  (The comparison gets really complicated if you try the model the real world with constantly changing rates.)

There is a major advantage to Roth accounts that is rarely mentioned and only applies if you max your contributions.  You can tax-defer more money via Roth!

Suppose 33% tax rates now and in the future.  In that case $10k saved in Roth is equivalent to $15k saved in Traditional.  But the contribution limits for 401ks is $17k/yr and for Roth 401ks is also $17k/yr.  If they wanted it to be a fair fight, they should only let you put like ~$11k/yr into Roth 401ks.  Until they do you are able to tax defer 33% more money by choosing Roth, which is huge.  For me this aspects of Roths is dramatically more important than speculated tax rates 50 years in the future, yet no one ever seems to mention it.

This same reasoning applies to the $5k you can put into Traditional IRAs and Roth IRAs.  You should only be able to put like $3.5k into Roth IRAs to be equivalent to $5k in Traditional...

akratic,

You are right.  Once you add the liquidity, and the lack of RMD requirements, the Roth becomes a pretty solid winner.

akratic wrote: There is a major advantage to Roth accounts that is rarely mentioned and only applies if you max your contributions.  You can tax-defer more money via Roth!

...For me this aspects of Roths is dramatically more important than speculated tax rates 50 years in the future, yet no one ever seems to mention it.

Yup.  But it's hard enough to get people to understand that X% taxes now is the same now as X% taxes in the future.  Now I wait to bring up the deferral advantage until people seem to be comfortable with percentages.

Things like if they take 33% off the top of account 'T' but not account 'R', to break even the 'T' account needs nearly 50% more money or the 'R' account 33% less.  (if it was 1/3 instead of 33% then 'T' would need exactly 50% more.)

edit:

but for most people it probably doesn't matter, because they aren't maxing out either option. 

AgAuMoney wrote:

akratic wrote: There is a major advantage to Roth accounts that is rarely mentioned and only applies if you max your contributions.  You can tax-defer more money via Roth!

...For me this aspects of Roths is dramatically more important than speculated tax rates 50 years in the future, yet no one ever seems to mention it.

Yup.  But it's hard enough to get people to understand that X% taxes now is the same now as X% taxes in the future.  Now I wait to bring up the deferral advantage until people seem to be comfortable with percentages.

Things like if they take 33% off the top of account 'T' but not account 'R', to break even the 'T' account needs nearly 50% more money or the 'R' account 33% less.  (if it was 1/3 instead of 33% then 'T' would need exactly 50% more.)

edit:

but for most people it probably doesn't matter, because they aren't maxing out either option. 

AgAuMoney, I LOVE your online name here. Chemistry much?

I think I understand what you're trying to say (in a nutshell: a certain amount of money in a Roth is already worth much more than that same amount of money in a tax-deferred account because money in a Roth doesn't have the promise of taxes looming over it, and thus the return for tax deferred accounts would have to be much higher than the return on Roth accounts in order to "beat" them because they would have to beat the taxes they are already behind AND the amount that the Roth has earned in the meantime), but I don't understand what you mean when you say "it's hard enough to get people to understand that X% taxes now is the same now as X% taxes in the future." That quote just really went over my head. Are you trying to say that people don't really think about how, even if they don't pay the taxes now, that the taxes are surely going to have to be paid someday? I would love to understand what you meant...

And I think I understand what akratic is trying to say- that if you're looking to really max out your contributions (which I am), if you put them in a Roth rather than in tax-deferred that's like *super-maxing* out your contributions, because a dollar in a Roth is worth intrinsically more than a dollar in tax-deferred because there are not taxes looming over it, reducing its current value even though it doesn't look like it on the surface.

Am I correctly summarizing?

sophie wrote: I am as well, for precisely the same reasons.  >90% of the advantage of the 401K is that immediate boost to the investment balance from the tax deferral, and you lose that with the Roth.

As for Roth vs. traditional, I may not be grasping the advantage of the "immediate boost to the investment balance" that traditional provides.  I agree that it exists but I don't yet see the advantage of it.  If we assume that tax rates remain constant (huge assumption, obviously), isn't Roth vs. traditional the same?  Since both taxation and annual compounding are multiplications, shifting them around should have no effect.

For example, if I start with $100 and allow it to compound at 5% annually for 30 years, I wind up with $432.  Let's say that I pay a 30% tax upon distribution and I'm left with $302.  If I instead use a Roth, I immediately have my investment balance knocked down to $70.  However, if I then allow this to grow at 5% annually for 30 years, I'm back up to the same $302 that I'd have had anyway.

Having said all of that, I do follow your strategy of weighting my contributions a bit more toward traditional rather than Roth.  The discussion on RMDs is always an interesting one, though, and gives me pause.  I have every hope of living to extreme old age but some of those RMD requirements are quite eye-popping when you reach 100 (about 16%)!  Of course, life expectancy (and thus the IRS tables) will also likely adjust by the time my wife and I pass the century mark.

I really have to make a lot of ill-informed predictions about a variety of things I have little knowledge of in order to play this "optimally". 

sophie wrote:The real solution is to get the Fair Tax passed.  What a magic bullet that would be!  All retirement accounts and the associated paperwork and complications would just go away.  Well, maybe not entirely because there is still state tax to deal with.

I have to say, the Fair Tax is a pretty nice plan.  The thing that troubles me, though, is that so long as the 16th Amendment exists, I would always be afraid that the government would "temporarily" bring back the income tax at any moment.  (And as we know, "temporary" doesn't mean the same thing when a politician says it as when you or I say it.)

Wow, I've tried to explain the "super-maxing" aspect of the Roth for years, but people always get bogged down in the math and miss my original point about how you can tax-defer more money via Roth (it effectively has a higher contribution limit).  Yet you guys got it right away!  I don't know if I'm getting better at explaining it, or this forum is just a special place.  My money is on the latter.

LW,

RMD's aren't a big deal for wealth you would have wanted to liquidate anyways.  However, discressionary spending is often best kept in something that's not basically forcing you to annuitize the balance.  Further, if you are quasi-annuitizing your pre-tax money (taking regular distributions for known expenses and maybe gaming the tax brackets a bit), it's probably going to be the Roth that ends up being a good chunk passed down to your kids, and fully liquid to them after the five year waiting period, though the IRS will apply RMD requirements to both Roth & Traditional inheritances, so either way it's got a bit of decay to it.

This is why I like HSA's... I get a FICA/medicare deduction (7.65%.. usually), can take it out tax free for medical expenses, and Medicare Premiums and long-term care Premiums (like it's a Roth) (I know it's not fun to think about taking withdrawals to pay premiums, but if my parents are any indication, insurance seems to make up about 30% of what excites retired folks  :-\), there are no RMD requirements, and when it passes to your kids there's no RMD decay like with Roth or IRA money.

moda0306 wrote: This is why I like HSA's... I get a FICA/medicare deduction (7.65%.. usually), can take it out tax free for medical expenses, and Medicare Premiums and long-term care Premiums (like it's a Roth) (I know it's not fun to think about taking withdrawals to pay premiums, but if my parents are any indication, insurance seems to make up about 30% of what excites retired folks  :-\), there are no RMD requirements, and when it passes to your kids there's no RMD decay like with Roth or IRA money.

If Medicare premiums are a legitimate expense, then how do you contribute to the HSA without any earned income?

MG,

You contribute to the HSA in the early years (medicare tax at that time is not deductible from HSA), but when you hit retirement, you can pay Part C and Part D premiums, which can total anywhere from $75-250 a month if I'm not mistaken, tax free.

Is that clear?

MangoMan wrote:

Lone Wolf wrote:
(And as we know, "temporary" doesn't mean the same thing when a politician says it as when you or I say it.)

What concerns me about the whole Roth concept is the promises of politicians. What if they change their mind about making Roth withdrawals tax-free at some point in the future, either explicitly or implicitly through income level phase-outs, etc? I'd rather take the tax break now, while I at least know that it exists and what benefit I am gaining from it.

That is an EXTREMELY good point.

MomTo2Boys wrote:AgAuMoney, I LOVE your online name here. Chemistry much?

I think I understand what you're trying to say (in a nutshell: a certain amount of money in a Roth is already worth much more than that same amount of money in a tax-deferred account because money in a Roth doesn't have the promise of taxes looming over it, and thus the return for tax deferred accounts

That's part of it.

The specific part in my post you were quoting, and to which I as responding, was concerned primarily with the amount you could put into the account.  To rephrase more simply, assumptions:  10% effective tax rate, just IRA accounts (no 401(k), etc), and there is 0% growth...

If you put $5000 into a traditional tax-deferred and deductible IRA it costs you $5000 and you will end up with $5000 in the IRA (0% growth) and when you take out the $5000 you will pay taxes on it, ending up with less than $5000.  If your all-in effective tax rate was 10%, you would end up with $4500 to spend.

If you put $5000 into a Roth IRA you already paid another $500 in tax so it cost you $5500 and you will end up with $5000 in the IRA and when you take it out you will end up with $5000 to spend.

In summary, you were able to use $5000 income with the traditional IRA, and $5500 in income to fund the Roth IRA, resulting in an extra $500, or 10% (your tax rate) additional saved.

If the numbers are larger, it is even better...

If you could max out your pretax or Roth of $20,000 and your net effective tax rate is 33% then the pretax would cost you $20,000 but the Roth cost you $26,600.  Effectively you were able to put away an additional 33% in the Roth and assuming the same returns and the same effective tax rate in the future it will always be worth 33% more to you, just like if they allowed you to put 33% more into the pretax IRA.

I don't understand what you mean when you say "it's hard enough to get people to understand that X% taxes now is the same now as X% taxes in the future."

If you have $Y today, and you pay X% taxes on it today, you will end up with $S spending money:
    S=Y-(Y*X)
or
    S=Y*(1-X)

If Y is $100 and X is 10%:
    S = 100*(1-0.10) = $90

Now let's assume a 100 times growth over the years.

If you put the $90 into a Roth account where it grows 100 times you will have an account balance of $9,000 and you can spend all $9,000.

If you put the $100 into a pretax account and it grows 100 times over the years your account balance will be $10,000.  But when you take it out (still the same X% and X=X):
    S = 10000*(1-0.10) = $9,000

Same amount of spending money.

If taxes stay the same rate, or X% now and X% in the future, you end up with the same amount of spending money.  Or in other words, paying X% taxes now is the same as paying X% taxes in the future.  The intervening growth does not making any difference.  The same is true in a taxable account, but only if ALL the tax rate EVERY YEAR stays the same (and that seems unrealistic).

So when trying to decide if you want to pay taxes now and invest what is left, or defer taxes and invest everything, the only factor that matters is what you believe your future tax rate will be compared to your current tax rate.

Of course it isn't quite that simple...  If you are on the cusp of the next higher marginal rate so that you are saving 45% tax rate now, and believe you will be in a lower bracket in the future then you are saying that you really believe your effective tax rate will be lower on those dollars.  I used to believe that, because that is what all the literature used to assume.  Then I realized I have children and mortgage and charitable deductions that reduce my current effective tax rate and those will mostly go away leaving me with a higher rate.  And tax rates are historically low right now, and historically the gov't mostly lets people move UP brackets because brackets are not inflation adjusted but income typically is somewhat inflation adjusted.  So I expect my future tax rate will be higher or at least as high as now.  But I cannot predict the future, so I try to spread money across tax deferred, tax free and taxable accounts hoping that no matter how the rules change I will not be 100% wrong in my choice of investing accounts.

Of course, all this applies to my USA situation.  Don't know how or if any of it applies in China.

Good luck with your 2 boys.

MangoMan wrote: What concerns me about the whole Roth concept is the promises of politicians. What if they change their mind about making Roth withdrawals tax-free at some point in the future, either explicitly or implicitly through income level phase-outs, etc? I'd rather take the tax break now, while I at least know that it exists and what benefit I am gaining from it.

While possible, I think it very unlikely they will put a direct tax on Roth withdrawals.

I think it more likely they will use Roth account balances in determining eligibility for SocSec (means test) or how much of your SocSec is taxable.

I think it is very likely they will institute a consumption tax and it won't matter that your Roth is not directly taxed.

Conspiracy idea:  By allowing and encouraging conversion of tax deferred assets to Roth assets they boosted current tax income by pulling future income into the present.  It makes "now" look good, at the cost of it hurting the future (like so many things they do).  This is one of the reasons (the other playing games with how the social security fund was accounted) why the late 1990's budget deficits decreased so much.  When the future rolls around, somehow the piper will need to be paid.

AgAuMoney wrote: If the numbers are larger, it is even better...

If you could max out your pretax or Roth of $20,000 and your net effective tax rate is 33% then the pretax would cost you $20,000 but the Roth cost you $26,600.  Effectively you were able to put away an additional 33% in the Roth and assuming the same returns and the same effective tax rate in the future it will always be worth 33% more to you, just like if they allowed you to put 33% more into the pretax IRA.

It is discussions like this which make me feel brain dead! Help me out:
In this example, the 33% "gain" is just offset by the 33% "loss" you take in your taxable investments, right? The benefit is more that you have shifted from taxable to tax free accumulation and withdrawal (which is huge). But aren't there are at least 2 faults with this argument:
1. This assumes that you are in the same tax bracket at retirement. Most people are in a lower.
2. Paying tax on the 20k now is at the marginal rate. If drawing off tax-deferrect acts at retirement, only that above $x will be subject to the marginal rate, so the effective rate is lower.

BearBones wrote:

AgAuMoney wrote: If the numbers are larger, it is even better...

If you could max out your pretax or Roth of $20,000 and your net effective tax rate is 33% then the pretax would cost you $20,000 but the Roth cost you $26,600.  Effectively you were able to put away an additional 33% in the Roth and assuming the same returns and the same effective tax rate in the future it will always be worth 33% more to you, just like if they allowed you to put 33% more into the pretax IRA.

It is discussions like this which make me feel brain dead! Help me out:
In this example, the 33% "gain" is just offset by the 33% "loss" you take in your taxable investments, right? The benefit is more that you have shifted from taxable to tax free accumulation and withdrawal (which is huge). But aren't there are at least 2 faults with this argument:
1. This assumes that you are in the same tax bracket at retirement. Most people are in a lower.
2. Paying tax on the 20k now is at the marginal rate. If drawing off tax-deferrect acts at retirement, only that above $x will be subject to the marginal rate, so the effective rate is lower.

I wrote a bit about this on the TSP vs. Roth TSP thread but regarding your issue to "1.)", while it is true that there is a reasonable chance you'd be in a lower tax bracket by the time you retire, with a Roth you aren't taxed on any gains and if you have money in there for 40 years-50 years, you'd have quite a sizable amount in capital gains that you wouldn't pay with the Roth but you would pay the whole thing with a Traditional 401k, just at a lower (potential) rate. I don't know what the balance point is but this is what steers me towards Roth in the early years of accumulation.

Pointedstick wrote:

moda0306 wrote:What about goods used to produce other goods?

Intermediate goods sold B2B are exempt. Only new goods sold at retail.

That seems like a loophole big enough to drive a truck through.  Simply get a corporate AmEx (I got one from Costco for the price of a yearly membership) and buy everything with it.  You even get cash back so it's almost like a negative tax rate... 

[quote author=BearBones link=topic=3074.msg41493#msg41493 date=1347069482
1. This assumes that you are in the same tax bracket at retirement. Most people are in a lower.
[/quote]

While this may have been true over the past 30 years, I don't expect it will be true in the future unless government disappears.  The gov't needs money and the need is increasing.  I suggest planning for taxes to increase.

It has not been true for many people I know.  While working they had many tax deductions that lowered their effective tax rate.  They were likely sheltering income into a 401(k) or IRA.  Now those tax deductions are gone and with inflation and travel and medical and etc. their cost of living is higher than expected, and thus the income they are taking has them paying a very similar if not higher net tax rate.

For example, my father has been retired for just over 10 years.  Taxes and insurance on his home are more than the entire mortgage payment plus taxes and insurance 30 years ago.  Utilities (electric and gas) use up the rest of the social security check.  Private savings and state pension cover food and medical and anything else.  He has been living in the same house for 40 years and is very conservative financially.  His annual income and expenses now are higher than 40 years ago, and he does not have dependents, mortgage interest, etc. to deduct.  However his medical expenses are deductible about every 2nd year.  His tax rate now is about the same as when he retired, and much higher than he was paying mid-career.

Storm wrote:

Pointedstick wrote:
Intermediate goods sold B2B are exempt. Only new goods sold at retail.

That seems like a loophole big enough to drive a truck through.  Simply get a corporate AmEx (I got one from Costco for the price of a yearly membership) and buy everything with it.

In what state does a corp AmEx exempt one from sales tax?  In CA, UT and ID you have to have a state number, which requires the letter of authorization from the state.  I'm sure some purchases end up tax exempt that should be taxed, but I'm sure that some of those abusing that exemption get caught (I've seen it in the news) via audit or whatever.  There is already well established infrastructure to detect sales tax fraud in every state that collects sales tax.