The Prevailing Principle to Win the Money Game
The Power of Compounding Pre-Tax Contributions and Accumulations:
With marginal income tax rates approaching or exceeding 50 percent, interest in tax deferral has spiked. Many are familiar with the opportunity and the advantages of investing income pre-tax, tax deferred. Instead of having only half their income to invest and losing investment earnings to yearly taxation, income deferral puts one hundred percent of the income to work and compounds the contribution at the pre-tax rate of return. As a result, accumulate greater capital and improve the retention of key personnel. But the conventional wisdom about income deferral is fraught with misconceptions. Here are the two most egregious myths.
Myth No. 1
There is no economic advantage to deferring income. Whether you get paid now or later, you end up with the same amount of money (That statement is a Myth).
Income deferral harnesses two wealth advantages. When you invest pre-tax, tax deferred, your income grows at the pre-tax rate of return, rather than the after-tax rate. If investment earnings are taxed at fifty percent, a ten percent return is eroded to five percent. By deferring, you would compound at the ten percent rate, and then pay taxes years later when you withdraw funds.
Myth No. 2
Non-Qualified Deferred Compensation (NQDC) is subject to its own tax rules, namely the constructive receipt and economic benefit doctrines. NQDC is commonly structured with investment flexibility. The prevailing model is to enables flexibility and opportunity for diversification or even a single investment.
The first purpose of a retirement plan structure is tax deferred gains and accumulations from which you can win the money game even when subject to full ordinary income tax rates upon withdrawal from your retirement plan and because:
a) The following statement is erroneous under standard assumptions:
It is sometimes said that capital gain property will suffer a tax disadvantage if placed in a tax deferred retirement account because the gain will be subject to full ordinary rates on withdrawal*.
(*See 402(b) Accounting).
b) Possible Confusions
However, make it clear that tax deferred accounts can be advantageous even for tax-preferred investments if those investments would be taxed at a rate higher than zero outside a tax deferred account.
Concluding that capital gain assets should not be placed in tax deferred accounts because they will be subject to ordinary income taxation on withdrawal is erroneous for these reasons:
it fails to take into account the tax benefit of excluding (at ordinary income rates) contributions to such accounts. Assuming that the applicable tax rate does not change, that benefit will be equal in present value to the burden of ordinary income taxation on withdrawal.
Reducing the tax burden to zero on ordinary income taxed at, say, 35 percent is obviously a greater advantage than reducing to zero the burden on capital gains taxed at, say, 15 percent.
A capital gains strategy is based on an illusion of the IRS current view of what is or is not a capital gain. The 402(b) is based on IRS ruling.
These relative advantages are important when limitations preclude placing all of a taxpayer’s investment assets in tax-exempt contribution accounts. The resulting tax “pecking order” for assets to be held in tax deferred accounts is often violated by investors, who may, of course, be subject to other constraints.
Although the conclusion that there is no tax advantage (or even a disadvantage) from placing tax-preferred assets in a tax deferred income account is mistaken, the relative advantage of exemption of investment income does depend on how the income would be treated outside such accounts.
* 402(b) Accounting follows classic accounting rules that distinguish between capital and income. Therefore 402(b) rules themselves will adapt those rules and not around the other way; which means that when the trustee pays out he will look at the source of that payment to determine if it is capital or income?
There are two issues:
1) tax law follows accounting rules and in particular in the area of trustee accounting what is quite clear what is capital must remain capital.
2) You can’t change the legal quality of capital. Capital arises in two ways:
a) capital injection; which for U.S. tax law terms is completely useless or the other way is the much more common way is
b) from income accruing and it is accruing in such a way that it is being accumulated and the trustee takes a decision to capitalize that income and adds it to the capital base.
Separating out capital gains from ordinary income is a huge benefit to effect lower tax rates.