To Pay or Not to Pay? That is the Tax Question!

I recently had a client ask the often asked question of whether he should pay taxes now, or if the option was available, to postpone/defer paying taxes. Immediate logic may lead one to go ahead and give Uncle Sam his due. Typically, this logic is not valid. Let's take a look at the various scenarios that an individual may face to bring about this tax-paying dilemma. The two most frequent events are: 1) pension plan distributions and 2) investment earnings.

Upon retirement, many retirees have to make distribution decisions about their pension plan. Since the vast majority of the value has been untaxed, the potential tax impact will be enormous and the decision will have a life-long impact especially since retirement success weighs heavily upon this plan (Note: never make this decision without professional consultation). The corporation will usually offer several payment options that must be considered along with tax consequences of which the IRS determines based on the option chosen. There are many planning factors that must be considered, therefore, a decision is based totally on individual circumstances. Considering the decision's magnitude, a retirement planning analysis is a must. Nevertheless, considering our current tax system, an argument for deferring taxes is justifiable, especially if one takes the time to crunch the numbers. This process will ultimately always lead to a deferment decision, which leads me to the next point.

The most common taxable decision facing retirees has to do with investment earnings, which come in many forms (e.g., bonds, stocks, mutual funds, certificates of deposit, savings accounts, Fannie Maes, Ginnie Maes, etc.). If earnings have to be spent to maintain one's accustomed manner of living then consider the following formula: i/(1-t), whereby i=tax exempt yield, t=tax bracket. This formula determines whether one should invest in tax-free municipals (munis) or taxable investments. For example, if a muni pays 5%, the taxable equivalent, assuming a 28% tax bracket is 6.94% (.05/(1-.28)). At this point an investor is said to be indifferent because the net income is the same. However, if one can find a yield higher than 6.94%, invest there, otherwise, stick with the munis.

On the other hand, if one does not have to spend the earnings, the tax question arises. To illustrate this point, let's assume: STEP #1 - an investor has a certificate of deposit valued at $25,000 earning 6%; tax bracket is 28%. Of the $1,500 (25000x.06) in earnings, $420 (1500x.28) goes to the IRS and $1,080 (1500-420) to the investor. Assuming all things remain constant, after five years the investor's account would be $30,400 (25000+(1080x5)). STEP #2 - in a tax-deferred investment, the five-year ending value would be $33,456 (25000x((1+.06)^5)). After paying taxes of $2,368 ((33456-25000)x.28), the investor's account would be $31,088 (33456-2368). This simple illustration of tax-deferment profited the investor $688 (31088-30400). As the investment, time frame, and interest rate increases, the additional value is magnified. Even though this illustration is simple, in the real world, it can make or break a secure retirement.

To add another twist to the above illustration, for retirees, new tax laws address the issue of modified adjusted gross income (MAGI). If one's MAGI exceeds certain predetermined amounts, a percentage of the excess, whether it be income or Social Security, is subject to additional tax. For those who are attempting to mitigate this tax by purchasing tax-exempt municipal bonds, forget it. Tax-exempt earnings are included in the formula. Tax-deferred earnings are not included in the formula. Mitigate is for those who investigate. Whether it be a pension distribution or regular investment, make sure you do your homework before you invest - no one likes surprises.

Gary Ellis, MBA, CFP