Re: Early retirees try to deal with tax deferred retirement

qwerty wrote:
"Islander" <nospam@xxxxxxxxxxx> wrote in message news:DoydndqbQr5o_wzanZ2dnUVZ_vamnZ2d@xxxxxxxxxxxxxxxxx
Thumper wrote:
On Fri, 18 Jan 2008 15:53:12 -0800, "qwerty" <nospam@xxxxxxxxxxxxx>
wrote:

"Islander" <nospam@xxxxxxxxxxx> wrote in message news:Se2dnd5pWIgEdQ3anZ2dnUVZ_gSdnZ2d@xxxxxxxxxxxxxxxxx
Jim Higgins wrote:
---[snip]---
DAY 4: Avoid pitfalls in managing your retirement fund
http://www.usatoday.com/money/perfi/retirement/2008-01-16-boomer-lump-sums_N.htm
Good article, but it just touches the tip of the iceberg of a problem that many retirees are beginning to face, How to invest your tax deferred retirement fund.

Moving your 401K into an IRA is the easy part. It gives more flexibility in investing and 20% is not automatically withheld in anticipation of the taxes due. Good things.
True.

But, try to find an investment adviser who understands the tax implications of investing this money!
Any competent investment advisor should understand the tax implications of an IRA.

Most of the advisers grew up in the era of the tax advantages of municipal funds, dividends, and capital gains.
IRA's have been around for nearly 25 years now.

Remember all the promises that were made to seniors about how reduction or elimination of taxes on dividends and capital gains? None of this applies to tax deferred investments. ALL gains are taxed at personal income levels when withdrawn.
Actually, all withdrawals (which includes the orignal capital) from an IRA are taxed as regular income.

Even more important, you lose the opportunity to offset capital gains with capital losses. SURPRISE! You have been screwed once again!
How so? Since you're not paying any taxes on the capital gains, interest or dividends in an IRA there's no need to offset with any losses.

So, what are the investment choices that work best for these accounts? You essentially have no tax advantage working for you.
Nonsense! You get years & years of compounding interest, dividends & capital gains without paying any taxes. As long as you keep your money in an IRA there's no taxes being paid! That's a HUGE advantage! You ONLY pay taxes when you make withdrawals from your IRA. That could mean up to 30-40 years of compounding interest, dividends & capital gains before ever paying any taxes on that money.

You got YOUR tax advantage when you avoided paying income tax when you put that money into your tax deferred savings account.
And you continue to accumulate wealth without any tax consequences until withdrawal. That's why the IRS REQUIRES that you start making minimal required withdrawals from your IRA upon reaching 70 1/2 years old. If the IRS thought it was to their advantage to leave your money in your IRA then wouldn't care.

Now, you are faced with the problem of how to make that money work for you without tax advantage, at a time when your investment strategy should be more conservative. Not easy to do and the investment community is not well prepared to help.
Please explain?

The number of complaints about questionable investment schemes is already increasing, especially in indexed annuities.
Annuities have been abused & oversold, but they can be extremely helpful to retirees, especially EARLY retirees since it's possible to withdraw money from your IRA without a tax penalty via annuities prior to reaching 59 1/2 years old.
I think the point he was trying to make is the argument put forth by
Bush that lowering capital gains taxes helps everyone because almost
everyone owns stock. It does really help the investing class because
every time they cash in an a share they pay less tax than a middle
class person who takes a disbursement from an IRA.
Thumper
Capital gains are only part of it. Our qwerty friend has bought into the argument that getting the government to leverage your investment is sufficient to offset the tax advantages that one realizes from after tax investments. The answer to that is, it depends. There is some analysis emerging that it might have been better for some to pay the tax and invest the money.

What? Instead of NOT paying the tax and still investing the money? Not paying the tax now allows MORE money to be invested NOW!

The extra percentage that employers kick in is treated like free money, but the employee would be better off with an increase in salary and the employer simply passes the increased labor cost along in any case. (Assuming, of course, that the employee invested it rather than simply spending it.)

My point had nothing to do with an employer kicking in any money, but with an IRA totally funded by an individual.

Let's take a few examples:

The most important is the loss offset. Everyone uses it, but few people talk about it because it is so obvious. Personally, I review my investments every December, selling the dogs and keeping the investments that have done well. Just plain good sense.

Not necessarily. You should "buy low and sell high"! If you use MPT and asset allocation you might very well be better off rebalancing by buying some of those "dogs". This is especially true if investing in index funds. When I need money I sell off some of my best performing funds (selling high) and when I have some cash to invest I buy some of the lowest performing ones. I know over the long haul via proper asset allocation that today's "dogs" will be the top performers in time and today's top performers will some day be the "dogs". Now this is probably counter intuitive to most people but makes absolutely good sense.

This allows me to groom my portfolio, selling some of my profitable investments without paying any tax on these profits.

Which in an IRA you wouldn't pay regardless.

The remainder I let ride. I can even pass some losses over to my other income. Depending on the size of your portfolio, one can live quite comfortably without paying any taxes, just on the income that you can draw from your investments in this manner.

For that to work you'd have to offset every profit with an equal loss. In other words you'd have to lose as much money as you made in profit. This doesn't sound like good investment advise to retirees. I prefer not to have ANY losses.

You don't get to do this in a tax deferred situation.

That's because it's totally unessessary in a tax deferred fund.

The balance of your gains and losses just sits there, waiting for you to withdraw it at which time you are taxed at the normal income rate.

Which is exactly the same as withdrawing from an IRA and you never have to worry about paying any capital gains tax.

Then there are dividends. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the tax on dividends for most taxpayers and this year dividends become fully untaxed for low income individuals. Bush claimed that this would benefit seniors. But, dividends paid into deferred tax accounts are eventually taxed as normal income. No benefit to seniors and, in fact, a tax penalty.

But those dividends, reinvesting without paying the tax now add up to considerbly more over the years. If you're in a low tax bracket (5%, 10% & 15%) then there is no tax penalty.

Now, qwerty seems to feel that the use of the relatively small amount of government money, compounded over the years, is sufficient to compensate for the higher tax paid by retirees.

You get to keep & earn interest on the taxes you would have paid in taxes. The government is essentially loaning that money to you at no interest so you can invest it and not pay taxes on the profits, at least not for years & years.

In reality, one only pays tax on after tax investments when you sell at a profit and then only when it is not offset by losses.

Sorry, but you seem to think that losses are a good thing. With an IRA you don't need the losses to offset the profits, you just get to keep the profits or simply reinvest them at no tax cost.

For those who do a lot of trading, that is important, but if one invests with an eye toward the long term, there is little difference between the two and after tax investments can be the better deal.

Sorry, but there is tremendous difference in the two over the long term. It's absolutely foolish not to take advantage of the tax advantages of an IRA, especially for long term investments. I fail to see how you cannot see that advantage.


A few points.

First, I would never advise someone to not invest in a 401K program. The encouraged discipline to put money aside is sufficient justification and for most employees, there will be no pay increase if they neglect to avail themselves of the employer contribution.

Second, I object primarily to the propaganda that the Bush administration spews over the supposed advantages of his tax cuts to seniors. They don't apply to tax deferred savings, the primary method of investing for most people, and your only counter argument is that there are other advantages. We are finding that these other advantages may not be such a good deal.

Third, everyone has a favorite investment strategy, but if you do not take advantage of the tax code to make your losses work for you, you are being foolish. (And, I don't believe that you have no losses unless you are only investing in CDs!)

Here, for your benefit, is a very old investment strategy that has been used successfully for decades.

Consider that your money is divided into two piles, one consisting of realized profit for which you no longer owe taxes and the other consisting of unrealized profit for which you will need to pay taxes as soon as you liquidate the underlying asset. Your objective is to increase the size of both piles while minimizing (or eliminating) taxes when you move money from one pile to the other.

Invest the money in both piles. I don't care how you invest it. You can throw darts at the WSJ, for all I care, but you will probably use your knowledge of the market to invest wisely. The only thing that you need to do is diversify as broadly as possible because nobody knows enough about the market to avoid all risk.

Your return on your investments will average some amount. Let's say that you are pretty good at this and you average a 10% return. Now, not all investments will return 10%. Some will, in fact, lose money. Some will return much more than 10%. We're talking average here, remember?

Now, you want to decide which investments to liquidate and which to retain. You can use any strategy that you want, but let's use a simple "survival of the fittest" strategy just to illustrate the method.

Sell the losers to create a capital loss. Sell enough of the middling to offset the loss. Keep the best performers.

Move the money that you "earned" from the sale of the middling from the unrealized profit pile to the realized profit pile, noting as you do so that you have paid no taxes on it. Note also that you have selectively increased the return in the unrealized profit pile to well more than your average return. And, when you finally sell anything in that pile, you will pay, at most, long term capital gains tax.

This strategy is compounding. Repeat it over whatever term you feel comfortable. You can even automate it if you want to let the computer do the work. Needless to say that there are many variations on this involving how investment decisions of what to retain and what to sell are made and you have identified one of these in your earlier response.

The bottom line is that this strategy cannot be used with tax deferred investments since there is no chance to write off losses. Yes, you get to use the money that you would have paid as taxes, but one has to balance that against the tax advantages of investing with non-tax deferred income.

Just incidentally, there was an interesting interview on Bill Moyer's Journal last evening with David Cay Johnston which touched on the issue of how the tax code favors the wealthy, a point that I have been arguing for years. For those who are interested, it is on-line at:

http://www.pbs.org/moyers/journal/01182008/profile.html
.

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