1999 Tax Guide: Long-Term Tax Planning

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Chapter 5
Putting a Long-Term
Perspective to Work

ecause the tax environment is constantly changing, it’s important for you to continually reevaluate your long-term planning strategies. This is particularly true of your planning for retirement. For example, when tax rates were low, deferring income was not always attractive. Depending on your own projection of future tax rates and other factors, deferral may again be very attractive for the next several years, particularly if you are subject to the highest tax rates.

Three principles should guide your long-term approach to tax and financial issues.

Principles for the Long Term

Maximize income deferral.
Evaluate investments on an after-tax basis.
Consider income shifting to maximize family wealth.

Maximize Income Deferral

The high tax rates on ordinary income and the abundance of tax brackets that exist today may prompt you to look hard for opportunities to defer income and the associated tax liabilities. Your best chances to defer significant amounts of ordinary income for the long term are generally in the area of earned income (such as salary and bonuses) and retirement accumulation plans. You may also have opportunities to defer tax by using qualified retirement plans and nonqualified deferred compensation plans. Maybe you don’t expect to be in a lower tax bracket when you receive the income. Even so, the ability to "invest" your pretax income and allow it to compound tax deferred for several years can be very attractive.

Table 5-1 shows you the power of tax-deferred compounding for three types of investments. The results are astonishingly different in all the years, but especially so in the longer time periods. For example, at the end of 20 years, Column 3 is $4,661, more than two times Column 1 at $2,021, and almost 45 percent greater than Column 2 at $3,216.

Column 1: You receive $1,000 and pay tax at 31 percent ($310); you invest the remaining $690 in a passbook savings account that earns 8 percent annually on which you pay tax at 31 percent each year.

Column 2: You receive $1,000 and pay tax at 31 percent ($310); you invest the $690 in a traditional nondeductible IRA, which allows the annual earnings to accumulate with no annual tax (that is, tax-free) and with no tax on the withdrawal of the initial after-tax contribution. The accumulated earnings will be subject to tax in the year of withdrawal.

Column 3: You avoid the upfront tax on the $1,000 and invest the entire amount in a tax-deferred account, such as a 401(k) plan or tax-deductible IRA. Eventually, when you take distributions out of the plan, you will pay income tax on them in the year received. Chapter 6 examines the opportunities that exist for long-term retirement-oriented accumulations. Many of these opportunities will be offered by your employer and are not directly under your control. But your ability to recognize them and to make the best use of them is important.

TABLE 5-1 The Power of Tax-Deferred Compounding 1999 Investments
	Type of Investment
	After Tax/Taxable Earnings (Example:Passbook Savings Account)	After-Tax/Tax Deferral on Earnings (Example: Nondeductible IRA)	Pre-tax/Tax Deferral on Earnings (Example: 401(k) Plan)
Value at end of:
5 years	$903	$1,014	$1,469
10 years	$1,181	$1,490	$2,159
15 years	$1,545	$2,189	$3,172
20 years	$2,021	$3,216	$4,661
25 years	$2,644	$4,725	$6,848
30 years	$3,459	$6,943	$10,063
35 years	$4,524	$10,202	$14,785
40 years	$5,919	$14,990	$21,725
Amount invested	$690	$690	$1,000
Assumptions: The individual earned $1,000 before taxes, is in the 31% tax bracket, and is earning 8% interest.

Evaluate Investments on an After-Tax Basis

The maximum tax rate on gains from property you hold for longer than 12 months is 20 percent. (There are different, more favorable rules for small business capital gains, and less favorable rules for collectibles and certain real estate.) Ordinary income is taxed at a maximum rate of 39.6 percent. It is likely that you will be in different tax brackets in different years. Except for municipal bonds, which are generally tax-exempt for federal and state purposes, most investment income will be subject to income tax at some point. For example, the interest on passbook savings accounts is taxed annually, and the appreciation in the value of a stock is taxed when the stock is sold, while dividends are taxed annually.

When you evaluate investment options, you should consider investment issues such as risk and asset allocation. And you should certainly consider the effect of income taxes. Generally, income taxes will decrease your investment return, although their effect will differ at various times. To be sure you are comparing "apples with apples," evaluate the performance of investments on an after-tax basis. This lets you make valid comparisons among investment options. Chapter 7 looks at the tax rules that affect investments and investment returns.

Consider Income Shifting to Maximize Family Wealth

Members of your family may pay substantially different tax rates -- from a low of zero percent to a high of 39.6 percent. These differences in tax brackets may encourage you to shift income and assets from high-bracket individuals to low-bracket individuals, who may include your children and grandchildren, as well as your parents. Unmarried individuals who are at least age 14 are subject to a 15-percent tax rate on income up to $25,750. Children under age 14 are generally taxed on their investment income at the same rates as their parents, excluding the first $700, which is not taxed, and the second $700, which is taxed at 15 percent. Trusts that accumulate income may also offer you planning opportunities. Chapter 8 reviews the opportunities that exist for shifting income and assets to family members.

Long-Term Tax Planning

You will want to identify and quantify your individual goals when looking at your tax and financial situation from a long-term perspective. For example, you may want to retire at age sixty-five and be able to spend $50,000 per year after taxes. If you are currently age 64, you don’t have a long time in which to implement a plan. You can, however, evaluate whether this goal is possible based on your current assets and projected retirement income and make some adjustments as a result. If you are currently age forty-four, you can have a substantial effect on your ability to make your goal a reality.

On the other hand, you may not expect to retire in the conventional sense. It might still be nice to know when you have achieved financial independence, however you define that term. By developing your own individual definition of financial independence, you can evaluate whether you have achieved it -- and still continue to work.

The rest of this book will focus primarily on identifying the tax issues involved in long-term planning and giving you some perspective on the long-term issues. For example, Table 5-2 shows how expenses will increase over time with inflation at 4 percent and 8 percent.

TABLE 5-2 The Effect of Inflation
	Cost of Living
Inflation Rate	Today	10 years from now	15 years from now	20 years from now
4%	$25,000	$37,000	$45,000	$54,800
	$30,000	$44,400	$54,000	$65,700
	$50,000	$74,000	$90,000	$109,600
8%	$25,000	$54,000	$79,300	$116,500
	$30,000	$64,800	$95,200	$139,800
	$50,000	$108,000	$158,600	$233,000

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