Thursday, February 24, 2005

The way we evaluate tax-deferred accounts in fundamentally flawed

(Part 1 of 5)

When using Microsoft Money to tally my net worth, it adds up my asset accounts, subtracts my credit accounts, and gives me a total. This is an unrealistic way to figure the value of any non-liquid asset; my house might be worth $120,000, but (even without a mortgage) I could not easily convert it to $120,000 sitting in my checking account.

Tax-deferred accounts, even if they’re filled with nothing but cash, are similarly non-liquid. While I can cash out an IRA or 401(k) on a few days’ notice if I really want to, doing so is very expensive. The bank who holds it is required to withhold 20% of any withdrawals. If I’ve got a balance of $1000, the largest (unrestricted) check they can give me is $800. Since I’m a middle-class 25%-rate taxpayer, I will incur an additional $50 liability to the federal government and $78 to my state (Idaho) government. Since I’m not yet 59.5 years old, there will also be a $100 early-withdrawal penalty. That means that while the balance printed on my IRA statement is $1000, I can really only convert it to $572 in spendable cash.

I’m not planning to access the money immediately. However, when I do access it, I hope to be earning enough income that I’m still at least in the 15% tax bracket. As of 2005, that means having less than $29,050 in taxable income. Even if I have stay below that (inflation-adjusted) boundary during retirement, I’ll still have to pay at least 22.8% of any withdrawals to one layer or another of government.

The true value of an IRA, 401(k), or similar tax-deferred account is the amount of cash that can be extracted from it. For an Idahoan like myself, that is somewhere between 57.2% and 77.2% of the balance printed on the monthly statement. Unless you’re planning to be significantly poorer in retirement than you are during your working years, it’s not really fair to say that you get to “keep” your money by putting it in an IRA. At best, you get to hold onto it for a little longer before giving it to the government.

Going back to my $1000 above, if my IRA doesn’t grow, and I am in the 25% tax bracket at retirement, then putting money into my IRA means that I trade $672 now for $672 later. The benefits of retirement accounts only appear when the money in them grows, or tax brackets change. Even then, those benefits are not as big as they might seem.