RETIREMENT BASED TAX SHELTERS

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RETIREMENT BASED TAX SHELTERS

• By Billy Jackson

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Retirement based tax shelters

• Retirement based tax shelters are investment
  funds that are not taxed until funds are
  withdrawn.
• Some examples
• 401k
• 403b
• Traditional IRA

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Benefits of the Program

• Benefits to the User
• Because of the assumption of a difference in the
  Marginal Tax Rate, there is a greater yield of
  money in the future.
• Since the money is withdrawn out of your gross
  pay, you have tax savings in the present.

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Benefits of the Program

• Benefits to the Economy
• Future consumption increases due to MTR
  inefficiency.5
• Assuming this causes an increase in willingness
  to save, assumes that this causes an increase in
  money in the markets.
• 401k investments increased from 92B to 1061B
  from 1984 to 1996 therefore, it creates
  incentive to save.5

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Retirement Investments As Market Failure

• The expected value is less than the actual value
• Poor anticipation of value of needs causes
  inefficiencyDWL.
• Shelter moves expected closer to actual via a
  subsidy.
• Must create a corrective subsidy.5

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Disadvantages of the Program

• Trade-offs
• Initial loss of income tax revenue.
• Loss on taxing the interest when withdrawn rather
  than taxing the gains annually.
• Opportunity cost of other goods by changing the
  relative return.

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Efficiency

• This program allows users to redirect gross
  income into an investment fund.2
• This tax savings for 1999 totaled nearly 87
  billion dollars.1
• Increasing the size of the economic pie by
  increasing investment into markets.

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Equity

• This is a progressive tax.
• Each fund has a ceiling investment level
  therefore, each investor has the same potential
  for savings.3
• This rewards those who save(i.e. rewarding those
  who can afford to save).

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Equity

• This program expands the Marginal Private
  Benefit.5
• Rewarding those who save.
• Burden of loss in tax revenue is borne by those
  who do not save.

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Stability

• CODAs (a.k.a. Cash of Deferred Arrangements) are
  market investments.
• This is a public good that is non-rival and
  non-excludable.
• The tax savings are encouragement to invest in
  the economy.

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Effects of Retirement Based Tax Shelters

• After-Tax Return on CODAs and IRAs.
• Reduces first period consumption by 1 minus the
  current Marginal Tax Rate.
• Increases second period consumption by
  (1-i)(1-t)
• i equals interest earned while in the CODA
• t equals the Marginal Tax Rate

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After-Tax Returns Effect on Personal Savings

• The Marginal Tax Rate (MTR) is lower in the
  future than in the present.4
• (Total in CODA)(Present MTR) minus (CODA)(Future
  MTR) equals tax savings.
• This is with the assumption of a change in their
  tax classification.
• When they receive their benefits, they are in the
  retired classification which has lower tax rates.

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Change in Tax Classification

• We see that future earnings increase while there
  is no change in present savings.
• This is good for stability by causing future
  growth in the economy.
• This all creates an increase in the utility of
  the consumer.5

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Retirement Based Tax Shelters

• Benefits
• The benefits for the economy and the consumer are
  the reasons why this program is effective.
• This program should continue to be in use.
• Disadvantages
• Tax payers bear the burden of disadvantages in
  the program.

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References

• Atkeson, Andrew Chari, V.V. and Kehoe, Patrick
  J. Taxing Capital Income A Bad Idea Federal
  Reserve Bank of Minneapolis The Region Vol. 23,
  No. 3, Summer 1999, PP. 1-12
• Individual Retirement Arrangements Internal
  Revenue Service, Publication 590, pp7-14
• Applegarth, Ginger. Special Report Tax-deferred
  plans for small and home-based businesses
  Microsoft bCentral
• Cover Story. Looking Beyond Investment Losses
  Kiplinger.com September 2001, www.kiplinger.com/re
  treport/archives/2001/September/cover.html
• Bruce, Neil. Taxes on Income Save for
  Retirement Public Finance and the American
  Economy Addison-Wesley Longman, Inc. PP 406-407,
  436-443