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Retirement Plans: 401(k)s, IRAs and Other Deferred Compensation Approaches 10th Edition by Allen, Joseph Melone, Jerry Rosenbloom, Dennis Mahoney
Edition 10ISBN: 9780073377421Retirement Plans: 401(k)s, IRAs and Other Deferred Compensation Approaches 10th Edition by Allen, Joseph Melone, Jerry Rosenbloom, Dennis Mahoney
Edition 10ISBN: 9780073377421 Exercise 1
For several years it has been argued that one of the primary advantages of a pension plan for employees is that it allows them to avoid taxation on a portion of their total compensation during the time they are in a high tax bracket and postpone the receipt- and consequently the taxation- of this money until after they retire. If, as was usually the case prior to the Tax Reform Act of 1986, the employee expected to be in a lower tax bracket after retirement, the tax savings inherent in this deferral could be substantial. However, if the federal income tax system evolved into a modified form of a flat tax system in which many taxpayers expected to be taxed at the same rate, regardless of when their money was received, does this necessarily imply that the tax advantages of private pension plans have ceased to be an important advantage for employees? (Hint: Even if all money received from a pension plan is taxed at the same rate, does the fact that money can accumulate at a before-tax rate of return, instead of an after-tax rate of return, affect the eventual amount of money received by the employee?)
?Although the point made in this question can be demonstrated in several ways, for simplicity assume there is one flat tax rate, no deductions, and all employees participate in defined contribution plans. This allows the question to be restated as follows: given a choice, should an employee elect to receive an extra dollar of compensation in the form of taxable wages and invested at an after-tax rate of return or defer it in the form of a pension contribution that is not currently taxable and receives a before-tax rate of return even though the entire amount will be taxable when distributed in the form of retirement benefits?
?Although the point made in this question can be demonstrated in several ways, for simplicity assume there is one flat tax rate, no deductions, and all employees participate in defined contribution plans. This allows the question to be restated as follows: given a choice, should an employee elect to receive an extra dollar of compensation in the form of taxable wages and invested at an after-tax rate of return or defer it in the form of a pension contribution that is not currently taxable and receives a before-tax rate of return even though the entire amount will be taxable when distributed in the form of retirement benefits?
Explanation
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If students are not familiar with present value techniques it is probably best to start with a relatively simple example. Assume an employee is age 60, plans to retire with a lump-sum distribution at age 65, and elects to defer $100 of compensation at the beginning of the year. If a tax rate of 28 percent is paid on taxable income immediately upon receipt and investments pay interest of 10 percent at the end of the year, the employee will have an extra $161.05 ($100 x 1.1 5 ) in the pension plan at retirement. After paying taxes of $45.09 (.28 x $161.05), an amount of $115.96 ($161.05 - $45.09) remains. In contrast, if the $100 was taken in wages, the employee would have paid $28 in taxes and received only $72 to invest. At the end of the first year, that amount would have accumulated to $79.20 ($72 x 1.1); however, taxes on the investment income of $7.20 amount to an additional $2.02, leaving the employee with $77.18 to invest the next year. After five years, the employee would have accumulated $101.93 ($72 x (1 +.1 x (1 -.28)) 5 ). The difference of $14.03 represents more than 12 percent of the after-tax pension distribution. This demonstrates that pensions continue to have important tax advantages, even in a flat-tax world.
This example only looked at the relative tax advantage of a single year's contribution. In reality, a pension plan consists of an entire career's worth of contributions. Ippolito calculates the tax-exempt earnings benefits of private pensions assuming a constant pension savings rate over a 30-year period. [5] Although the math is beyond the scope of an introductory pension course, the results are worth noting. Assuming an interest rate of 8 percent and a flat tax rate of 25 percent, the tax gain from the interest tax exemption was 18.6 percent of pension income. This represents the portion of (before-tax) pension retirement income that would otherwise have been collected as tax on interest earnings if the same pension contributions had been saved outside the tax-exempt pension plan.
This example only looked at the relative tax advantage of a single year's contribution. In reality, a pension plan consists of an entire career's worth of contributions. Ippolito calculates the tax-exempt earnings benefits of private pensions assuming a constant pension savings rate over a 30-year period. [5] Although the math is beyond the scope of an introductory pension course, the results are worth noting. Assuming an interest rate of 8 percent and a flat tax rate of 25 percent, the tax gain from the interest tax exemption was 18.6 percent of pension income. This represents the portion of (before-tax) pension retirement income that would otherwise have been collected as tax on interest earnings if the same pension contributions had been saved outside the tax-exempt pension plan.
Retirement Plans: 401(k)s, IRAs and Other Deferred Compensation Approaches 10th Edition by Allen, Joseph Melone, Jerry Rosenbloom, Dennis Mahoney
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