New Strategy - STOP Deferred Income!!

[Snaggletooth]

My 62-year-old brother-in-law followed traditional tax advice for years -- he now has a substantial amount of money tied up in an SEP. He asked me this year how much he should put into his SEP as his business had a decent year.

My answer? ZERO!! Why did I tell him that? Isn't it sacregligious for a tax man to advise AGAINST deferral of income??

Before you think I'm crazy, better listen. In 8 years (assuming he lives), he will have to begin drawing out his SEP. This will be taxed at ordinary income rates. I have other customers who are now having to withdraw these retirements and their income is greater now than when the contributions were deferred. A sure-fire turnaround of strategy.

As an alternative, he will buy 3 stocks per year for the next few years. If they pay dividends, he will be taxed at 15%, maximum. If he sells them, he will be taxed at 15% maximum. If he sells his losers, he can write off a LOSS up to $3K per year. If he has big winners, he doesn't have to pay on them until he sells them.

At some point during the craze over SEPs, 401ks, 403bs, etc. we have to realize that ultimately we are converting favorable dividends and capital gains rates to ordinary income rates. The analogy, of course, does not hold true for a Roth, but these benefits are primarily for younger contributors.

Have I advised him wrong?

[rosieea]

.

As an alternative, he will buy 3 stocks per year for the next few years. If they pay dividends, he will be taxed at 15%, maximum. If he sells them, he will be taxed at 15% maximum. If he sells his losers, he can write off a LOSS up to $3K per year. If he has big winners, he doesn't have to pay on them until he sells them.

At some point during the craze over SEPs, 401ks, 403bs, etc. we have to realize that ultimately we are converting favorable dividends and capital gains rates to ordinary income rates. The analogy, of course, does not hold true for a Roth, but these benefits are primarily for younger contributors.

Have I advised him wrong?

I think the question really is, how long will it take before the benefits of a lower tax rate outweigh the tax savings realized by deferring income? And what does one do with the tax saved by deferral? Spend it or save it? Sounds like a question for an actuary.

[Unregistered]

I agree Snaggletooth

I think you are correct, a lot of times these deferrals make the social security ben.
85% taxable.

Dixie in NC

[LawrenceGR]

That is a good idea

I'd have to say I have never considered that angle. I have a couple he is 62 she is 54 they both started a ROTH I don't think this is going to pan out the way they hoped. Sometimes people have selective hearing, they hear the part "Tax free" but they don't look at the nuts and bolts of the program. I do very much like your idea of buying stock and I am going suggest this to some of my clients (No I don't sell investment products or annuities) that want to save for the future. I had a guy a couple years ago where his daughter received 100 sh of stock at birth for college, she had almost enough money to pay for her first year.

[Bees Knees]

You also have to consider the cost of not deducting those SEP contributions this year at ordinary tax rates. If your client is in the 28% federal tax bracket this year, NOT putting that money in a SEP will COST him $280 for every $1,000 he doesn't contribute.

The reason the distributions are taxed at ordinary rates when withdrawn is because the contributions were deducted at ordinary rates. And the earnings were not taxed when earned.

You might think, yeah, but I only pay tax at 15% on the earnings each year if I don't put it into a SEP.

True, but would you rather pay 15% each year for the next 8 years, or wait 8 years and then pay 28%? How much could you have earned on the 15% you pay every year if you left it in the account?

Tax deferral is immediate. It produces results. You don't know that he will pay tax at 28% 8 years from now. He might not pay any tax as far as you know. A lot can change in 8 years.

[stern100]

Tax deferral is immediate. It produces results. You don't know that he will pay tax at 28% 8 years from now. He might not pay any tax as far as you know. A lot can change in 8 years.

including the 15% cap gains rate, which will probably move up once the dems take control.
remember, its considered a rich mans tax break.

[Bees Knees]

Another point, it is not just the earnings that are deferred for the 8 years. It is also the tax savings on the contribution that is deferred for eight years.

Example:

$1,000 that could be put into a SEP, or used to purchase stock. Assume 5% rate of return each year, and a 28% tax bracket going in and coming out of the SEP.

With the SEP, you save $280 in taxes in year one. So the full $1,000 gets invested.

Year 2, balance equals $1,050.
Year 3, balance equals $1,103
Year 4, balance equals $1,158
Year 5, balance equals $1,216
Year 6, balance equals $1,276
Year 7, balance equals $1,340
Year 8, balance equals $1,407

Year 8, balance is withdrawn and taxed at 28% = $394.
Balance to spend after tax = $1,013.

Without the SEP, you only have $720 to invest after paying tax at 28% on the $1,000 that you did not contribute to the SEP.

Year 2, balance equals $756, minus 15% tax on earnings = $751.
Year 3, balance equals $783 after 15% tax on earnings.
Year 4, balance equals $816 after 15% tax on earnings.
Year 5, balance equals $851 after 15% tax on earnings.
Year 6, balance equals $887 after 15% tax on earnings.
Year 7, balance equals $925 after 15% tax on earnings.
Year 8, balance equals $964 after 15% tax on earnings.

There is no tax on the withdrawal because the tax was paid each year.
Balance to spend after tax = $964

Which would you like to have in 8 years after tax? $1,013 or $964?

[Snaggletooth]

All kinds of Angles

...to look at this. Yes, we had to forego a $10,000 deduction (at a 25% rate) this year, which would have yielded $3k immediate cash. I have, however, been tracking the taxability of those customers who invest in individual stocks, and their EFFECTIVE tax rate is less than 3%. How can this be? I would offer three points of interest:

1) Unless you have employer contributions such as a 401k, these so-called "administered" funds are ripping people off. A retirement plan with mutual funds was the best thing going until about 10-15 years ago. Then the insurance companies and banks started offering shrink-wrapped versions of the major funds where they skim more money off the top. The fee can be as much as 4% on top of the admin fee charged by the mutual fund. I don't know anyone who has diversified their individual stocks who has not outperformed the "administered" funds in the last 10 years. Insurance companies call their product "Variable Annuities" and this is their latest attempt to fool the public now that their cash-value products have been exposed for the gouging that they are.

2) Dividends are very paltry nowadays. If you can find a stock whose dividend per share is more than 2%, better buy it. $10,000 invested in a bank CD gives you $350 in ordinary income interest. The same $10,000 invested in an array of stocks may result in $50 dividends taxed at capital gain rates, after allowing for most stocks not paying any dividends at all.

3) What about capital gains? This is the ULTIMATE tax deferral, since you don't have to sell your big gainers. You don't have to sell them when you turn 70, or ever. You can even donate some of them to charity instead of cash. Your losers? Sell them every year! and deduct as much as $3000 off your taxes! What if you sell losers which generate more than $3000? Then you can sell a $3000 winner and pay nothing, or do nothing and take another $3000 in the following year!

You don't have these options with mutual funds, who are doing the diversitication for you. You get a 1099-DIV from them every year, and lose the control of managing your gains and losses.

Thus the REAL taxation of individual stocks, although nominally with a 15% ceiling, is actually next to zero.

Dixie from NC - good to hear from you. Log in under your name and we'll know who we're talking too. No one will really know who you are or where you live, but we can assume North Carolina and let it go at that.