Question about re-investing returns...

  • Thread starter Afterwards Hilarity Ensued
  • Start date

A

Afterwards Hilarity Ensued

How damaging or costly is it if somebody doesn't reinvest returns realised
thru tax shelter investments?

For Example I invest far below my allotted cap room inside my RRSP's (that's
like an IRA or Roth or something like that for Americans)

However any money that I do invest inside this tax shelter will lower my
taxable income so I should be getting about 30% of what I invest in that
retirement plan this year at income tax refund time next spring.

However I only allocate 25% of my total monthly savings/investment funds in
the tax free retirement plan shelter. This money is invested in Mutual
funds (20% aggressive growth, 50% moderate growth, 30% safe growth) The
other 75% is invested outside tax shelters or in simple 30 day deposit
certificates and mutual funds. I do this for now because I am still
building savings accounts for emergency funds, and big ticket life
purchases. Sure I pay the taxes on the returns but then the funds are free
and clear to spend. With a tax sheltered retirement I never plan on
touching it until I retire.

I had planned on using my tax return to re-invest outside of my tax free
growth investments because those will be more pressing needs but would this
be a costly mistake in building a retirement portfolio? in other words
should I re-invest the tax returns realized from retirement investing into
that same plan? What would be the long term cost to my retirement
portfolio?

This is my first year of investing so It's all new to me. Keep in mind I
won't be spending my tax return rather deciding how to reinvest.

Here are my facts:

-30 so retirementis in say 30 years give or take a few years
-Single
-Rent
-will not buy home until married or for another 5 years
-NO debts (credit cards, cars, lines of credit, family etc. I owe nothing!)
-NO university debts (high school drop-out)
-blue collar income
-currently have 6 months pay saved but will want this at 12 months
-first year of my adult life with a savings account and investments.
-Saving/ investing approx 50% of my after tax income each and every month
-no additional contributions from employer, government, family. All money
is from my pocket.
 
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B

Bucky

Afterwards said:
How damaging or costly is it if somebody doesn't reinvest returns realised
thru tax shelter investments?
It took me a while to understand your question because the phrasing
made it sound like you were asking about re-investing dividends and
distributions. But if I understand correctly, you're really asking
about investing the tax refund/credit.

I don't know the details of Canadian tax system, but if it's the same
as U.S., then you're not getting a tax refund, you actually never had
to pay it in the first place. (The ideal thing to do is to adjust your
tax witholding so that you pay less taxes by the same amount, instead
of waiting to get the refund the next year.)

Since you say your tax bracket is 30%, that means that you will earn
roughly (very roughly) 30% less outside the RRSP. So if you could earn
10% annually in the RRSP, it would only be about 7% outside RRSP. With
compounding, that can become a huge difference over decades (2x over 20
years).
 
A

Afterwards Hilarity Ensued

Afterwards Hilarity Ensued wrote:

It's impossible to calculate what the long term cost would be. If you
are maxing out your RRSP's then any future realized tax advantages
cannot be invested further into the RRSP, right? (Cause you are already
maxed out.) Otherwise any slack you left would be so much less for
your future retirement.
That is right. Anyt ax advantages I would get cannot be used to put into
the RRSP unless I did not max out. Fornately, or unfortunatley, I have 6
years worth of unused contribution space that I am allowed to carry forward
into the current tax year so in my case I would be allowed to reinvest my
tax refund.
Your investment in RRSP grows tax deferred. Investment outside the
RRSP you'll have to pay tax on annually.
But do I put all my energy and found money into retirement funding i.e.
RRSP's? Should I be maxing out and putting everything into that tax
deferred investment when I'm 30? Am I supposed to top that fund up first
before anything else?

Keep in mind I have NO DEBTS or credit card balances or car loans etc. I
owe nobody a single cent, expect the landlord and the tax people.
 
J

joetaxpayer

Afterwards said:
But do I put all my energy and found money into retirement funding i.e.
RRSP's? Should I be maxing out and putting everything into that tax
deferred investment when I'm 30? Am I supposed to top that fund up first
before anything else?

Keep in mind I have NO DEBTS or credit card balances or car loans etc. I
owe nobody a single cent, expect the landlord and the tax people.
In the US, the tax rates are graduated, so that an individual pays 15%
for taxable income over $7550, but 25% for income over $30,650, and
ultimately, 35% for income over $336,550.

We run the risk of over saving in tax deferred accounts and then paying
too much tax at withdrawal. And some other oddities when social security
income is added. So the answer in the US is to deposit enough in our
employer account (here, a 401k account) to capture the matching funds
given by the employer. Then, other savings, post tax.

Not knowing the specifics of the Canada tax code, I'll leave the further
comment to someone more familiar with it.
JOE
 
A

Afterwards Hilarity Ensued

joetaxpayer said:
In the US, the tax rates are graduated, so that an individual pays 15% for
taxable income over $7550, but 25% for income over $30,650, and
ultimately, 35% for income over $336,550.

We run the risk of over saving in tax deferred accounts and then paying
too much tax at withdrawal. And some other oddities when social security
income is added. So the answer in the US is to deposit enough in our
employer account (here, a 401k account) to capture the matching funds
given by the employer. Then, other savings, post tax.

Not knowing the specifics of the Canada tax code, I'll leave the further
comment to someone more familiar with it.
JOE
The people in misc.can.invest and can.general know little of financial
planning and know far more about buying penny stocks. I am slowly but
surely learning Canada's tax codes from google every day!!!!!

In Canada we have 3 or 4 federal tax brackets. Also the provinces have
their own tax brackets. The first tax bracket is for income from $1 to $36
500 per year and this rate is $15.25% for 2006
The second bracket is 22% and applies to income between 36 500 and 78 500.
So if you made $75 000 you are taxed 15.25% of the first 36 500 and then 22%
for the remainder. In my province of Ontario the income tax is 6% for the
first 34 000 and 9% for the amount between 34000 and 68000 and 11% on the
amount after $68 000.

So In Canada at least people try try try to get themselves into that lower
tax bracket by reducing taxable income. Invest in tax deferred retirement
schemes is the easiest way to do this and if you get into that lowest
bracket you are looking at some nice refunds.

However alot of people borrow short term money to put into those investment
shelters and then they take their refund and pay back the loan or a portion
of the loan.

However Joe you raised a good point. I picked moderately aggressive growth
funds. If these funds have a couple stellar years I could run the risk of
getting into a HIGHER tax bracket come time to withdrawal from my retirement
tax deferred investments. So maxing out tax deferred contributions could be
a negative in the future, esp. if I am scheming to save taxes now in my
youth. Since my employer offers no pension or matching contributions I
felt I'd have to work twice as hard to give to my plan. But what if my
investments did really well in that shelter? I could be saving my way to
higher taxes. I would be robbing myself from the past.

So only max out IF your employer matches (that's free money).

I'm glad you raised that point. Since I have a 30 year plan there is real
risk of oversaving. I have to read the tax code rules (like they will be
the same 30 years from now LOL) and find out what the MAXIMUM withdrawal I
can make from these tax deferred investments once I am retired and convert
the plan into income. IF there is no max then it could be tax trouble down
the road. If there are Maximums on withdrawls maybe I won't pay alot of
tax on any potential oversavings.


======================================= MODERATOR'S COMMENT:
Please trim the post to which you are responding. "Trim" means that except for a FEW lines to add context, the previous post is deleted.
 
J

joetaxpayer

Afterwards said:
If these funds have a couple stellar years I could run the risk of
getting into a HIGHER tax bracket come time to withdrawal from my retirement
tax deferred investments. So maxing out tax deferred contributions could be
a negative in the future, esp. if I am scheming to save taxes now in my
youth. Since my employer offers no pension or matching contributions I
felt I'd have to work twice as hard to give to my plan. But what if my
investments did really well in that shelter? I could be saving my way to
higher taxes. I would be robbing myself from the past.
And so the advice I've come to offer here, to reasonable acceptance, is
that one should diversify across their taxable/ non taxable accounts as
well [as diversifying amongst asset classes]. So at retirement you stand
a chance of controlling to some degree where the income will come from
and be able to moderate your tax burden a bit.
In the states, we also have the issue that our 401k withdrawal is
'ordinary income' and taxed at one's higher, marginal rate. Post tax
money giving off dividends and/or long term gains are taxed at a
favorable 15% maximum rate. So, money put in pre-tax, not matched, can
cost the investor more in the long term.
It looks like the Canadian structure is similar, in that sense.
JOE
 
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A

anoop

joetaxpayer said:
We run the risk of over saving in tax deferred accounts and then paying
too much tax at withdrawal. And some other oddities when social security
income is added. So the answer in the US is to deposit enough in our
employer account (here, a 401k account) to capture the matching funds
given by the employer. Then, other savings, post tax.
Is this really true? I thought the general consensus was to get the
employer match, then do the Roth (where you invest post tax but the
gains are tax free) and then again go back to the traditional plan and
max out. I haven't seen anything that says to get the employer match
and then look to post-tax saving. If the employer didn't match
anything, the above logic would imply that all savings should be
post-tax.

Also, I think the advice would vary on income level. For someone
with very high income, it probably doesn't hurt to save as much as they
can in tax-deferred accounts.

Anoop
 
J

joetaxpayer

anoop said:
joetaxpayer wrote:




Is this really true? I thought the general consensus was to get the
employer match, then do the Roth (where you invest post tax but the
gains are tax free) and then again go back to the traditional plan and
max out. I haven't seen anything that says to get the employer match
and then look to post-tax saving. If the employer didn't match
anything, the above logic would imply that all savings should be
post-tax.
Yes, the advice would vary based on income. Also - I was replying to a
Canadian poster, I don't know if a Roth type vehicle was available to
him. Matched 401, then Roth or post tax IRA deposit with an eye toward
Roth conversion. Side by side, a non-matched 401 vs post tax accounts
are not quite a no brainer, but I've written spreadsheets that show that
even with the tax deduction up front, the loss at the same rate upon
withdrawal is a hit. The post tax savings enjoy a lower tax rate for
Dividends or long term gains. So I do believe the 401k needs to be
scrutinized a bit when deciding how heavy to invest. For example, a 50
year old who now needs to save as much as he can for retirement with
little saved. He may easily go from a high bracket to the 15% bracket at
retirement. 401 to the max. A young person with good prospects starting
out in the 15% bracket probably shouldn't save in the 401 beyond the
match. For her, the Roth is the best way to go.

JOE
 
W

wyu

Let's take a step back -- try not to let the fear of taxes blind us to
the actual numbers.

Here's a question. Would you prefer to pay $10,000 per year in taxes or
$1,000,000 per year in taxes? For myself, a no brainer. I'd pay the $1M
because that means my income is $2M versus paying $10K of taxes on $30K
of income.

Getting back to your situation, the money you put in now grows
tax-deferred. So let's run some simple numbers to see what happens. Say
you put in $10K a year post tax versus $13.3K pre tax @ 10% growth,
100% distributions, 25% tax rate now and future. Here are the cash-out
schedule for years 1-10.

Year 1: 10,000 post tax versus 10,000 tax deferred cashout
2: 20,750 - 21,000
3: 32,306 - 33,100
4: 44,729 - 46,410
5: 58,084 - 61,051
6: 72,440 - 77,156
7: 87,873 - 94,872
8: 104,464 - 114,359
9: 122,298 - 135,795
10: 141,471 - 159,374
20: 433,037 - 572,750
30: 1,033,994 - 1,644,940

After 10 years, you're talking 12%+ for tax defered over a fully
taxable account. Keep running the numbers and you see 32% after 20
years. After 30 years, it's 59%. So that extra 59% might be taxed at a
higher bracket. Go back to my hypothetical question about how much
taxes you'd rather pay. That still leaves you with a higher post-tax
amount assuming you took everything out at once. (You do have the
option of taking out X amount every year to stay within some arbitrary
tax bracket.)

Now it is more complicated than this. Using low turnover index funds
will reduce the yearly tax drag for taxable accounts. Capital
gains/qualified dividends may or may not be taxed better depending on
the political climate. Global/national economic picture might be
different forcing higher taxes all around. But I'd certainly plan for
overinvesting versus underinvesting.
 
J

joetaxpayer

Let's take a step back -- try not to let the fear of taxes blind us to
the actual numbers.

Here's a question. Would you prefer to pay $10,000 per year in taxes or
$1,000,000 per year in taxes? For myself, a no brainer. I'd pay the $1M
because that means my income is $2M versus paying $10K of taxes on $30K
of income.

Getting back to your situation, the money you put in now grows
tax-deferred. So let's run some simple numbers to see what happens. Say
you put in $10K a year post tax versus $13.3K pre tax @ 10% growth,
100% distributions, 25% tax rate now and future. Here are the cash-out
schedule for years 1-10.
Your math is compelling, but makes some assumptions that may be right or
wrong. Are you assuming the 401(k) has the same expenses that the post
account funds do? In my reply to the OP, I should have pointed out that
401(k) fund expenses, good or bad, should be taken into account. Try
adjusting your calculations using .20-.40% annual incremental expenses
and the advantage fades quickly.
Also, it's been discussed here that there are phantom rates as high as
50% which hit when additional income causes Social Security to be taxed.
That situation calls for post tax money.
Lastly, consider this - in the final year one works, in the 15% bracket,
he saves in the 401(k), but in the very next year, the first year of
retirement, starts drawing enough that he's in the 25% bracket. Of
course this can work in reverse, the one year deferral saving him the
10% difference.
In the end, I didn't claim the pre-tax savings is always bad or good,
just that there's a need to be aware of the possible trap at the other
end. Given that tax laws can and do change, not putting all your eggs in
the pre-tax basket seems sound advice.
JOE
 
A

anoop

joetaxpayer said:
Yes, the advice would vary based on income. ..
So I do believe the 401k needs to be
scrutinized a bit when deciding how heavy to invest.
At least in the US, there are other things to keep in mind.
Most tax-deferred retirement plans are protected in case the
person gets sued and/or goes bankrupt. You also can't
make much in terms of catch-up contributions, so I think
it makes sense to take as much advantage of them while
you can. I've always thought of maxing out on the 401(k)
as a no-brainer and I've yet to see something that can
convince me otherwise.

Anoop
 
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W

wyu

Obviously, things get complicated when you take in all the factors. I
already issued that caveat. My post was mostly addressing this quote
from the OP:

"But what if my investments did really well in that shelter? I could
be saving my way to higher taxes."

The statement just screams to me irrational fear of taxes. Throwing
away higher possible net-after-tax returns because the total $/% of
taxes is higher? Crazy.
 
A

Afterwards Hilarity Ensued

Obviously, things get complicated when you take in all the factors. I
already issued that caveat. My post was mostly addressing this quote
from the OP:

"But what if my investments did really well in that shelter? I could
be saving my way to higher taxes."

The statement just screams to me irrational fear of taxes. Throwing
away higher possible net-after-tax returns because the total $/% of
taxes is higher? Crazy.
Well I was the OP and the whole question thread started about what to do
with my tax refund that was given to me specifically because I invested in a
tax deffered plan. I also as the OP said this was my first year of
investing so I have some pretty silly question I'm sure. But shouldn't
careful consideration of taxes be a factor to those of us who are blue
collar worker types?
 
W

wyu

Refer back to the numbers in my first reply. You absolutely will pay
way more in taxes over the long run if your money is in the tax
deferred account. 225K+ more for the 30 year example! Seems crazy that
paying nearly a quarter of a million more in taxes could ever be
beneficial. But the key is that tax deferred investments grow a lot
faster than investments taxed every year (assuming
expenses/returns/options are equal). The reason you pay $$$ more is
because tax deferral allowed your investments to grow an extra 1.1M --
575K of that is yours after tax. (Taxable: earn 1.333M, tax 333K, net
1M versus Tax-deferred: earn 2.1M, tax 525K, net 1.575M.) The point
here is to look at the net return numbers. If you pay more in tax but
you still take home more money, that's better than paying less in taxes
because you take home less net.

Previous messages have stated there's no guarantee that tax laws will
not change. Maybe you will be in a much higher bracket. And maybe the
world will be in a global depression where taxes have to be raised
massively. (And likewise, there's no guarantee the favorable tax status
of LTCG and QDIV will remain in place either.) Let's calculate what
your margin for increase is in the 30 year example. 1-(1/2.1) --> 53%.
Your overall tax rate (not the top marginal bracket) can go as high as
53% and still match the performance of the fully-taxed account that was
taxed at 25% every year. A jump from 25% to 53% the year you happen to
retire won't happen (unless you decide to cash the entire thing out to
buy an island versus taking 5% out every year for your living expenses)
-- the entire country would revolt. If the tax was slowly increased
over time, that would also severely reduce the performance of your
taxable accounts.

Previously, I used a very simple example to illustrate the benefits of
tax-deferred growth. Let's throw in low-turnover index funds using 1%
taxable distributions+9% unrealized gains per year. (1% is being extra
favorable since the typical equity fund yield is ~2% with 5%+ for bonds
and REITs.) Assume you can invest in the same index funds in a
tax-deferred account with the same level of fees. Now we have:

10 year: net 144K versus net 159K
20 year: net 474K versus net 572K
30 year: net 1.28M versus net 1.64M

After 30 years, an extra 250K in a taxable account using index funds --
much better than actively managed funds with high volumes of
transactions. And yet still netting 360K less after all taxes versus
tax deferred growth. Your tax increase margin is now 41%. 25% to 41% --
still very improbable for a 1 year jump.

As for these numbers being applicable to blue color workers - I used a
simple $10K after-tax contribution per year as an example. If you put
$5K in per year, divide all the final numbers by 2. If you put $2500
in, divide by 4. The ratios and percentages stay the same.
 
B

Bucky

Afterwards said:
But shouldn't
careful consideration of taxes be a factor to those of us who are blue
collar worker types?
Definitely tax consideration is a big factor, that's why RSPP is
better. You shouldn't be afraid of earning more money on account of
paying more taxes. Keep in mind that tax brackets are marginal, you
will never be worse off hitting a higher tax bracket. The bottom line
is that the exact same investment in the RRSP will result in more money
in your pocket than outside RRSP.
 
J

joetaxpayer

Bucky said:
Definitely tax consideration is a big factor, that's why RSPP is
better. You shouldn't be afraid of earning more money on account of
paying more taxes. Keep in mind that tax brackets are marginal, you
will never be worse off hitting a higher tax bracket. The bottom line
is that the exact same investment in the RRSP will result in more money
in your pocket than outside RRSP.
One question for the OP - Do you know what the expenses are for the
funds within your RSPP? It would be expressed as a percent, say 1.2%, or
hopefully in basis points as in 25 bpts (which is .25%). This would help
the precision of the replies. Assuming the fees are low, as low as you
could find outside the account, I lean back toward this answer. If the
fees are higher, that pushes me back to my original position.

Disclaimer - the first I remarked on this I was using a spreadsheet
written for VA comparison to taxable accounts. The minimum fee of .25%
still added up over time to negate the benefit of tax deferral. The
detailed numbers wyu posted set my error straight.
JOE
 
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Z

zxcvbob

Refer back to the numbers in my first reply. You absolutely will pay
way more in taxes over the long run if your money is in the tax
deferred account. 225K+ more for the 30 year example! Seems crazy that
paying nearly a quarter of a million more in taxes could ever be
beneficial. But the key is that tax deferred investments grow a lot
faster than investments taxed every year (assuming
expenses/returns/options are equal). The reason you pay $$$ more is
because tax deferral allowed your investments to grow an extra 1.1M --
575K of that is yours after tax. (Taxable: earn 1.333M, tax 333K, net
1M versus Tax-deferred: earn 2.1M, tax 525K, net 1.575M.) The point
here is to look at the net return numbers. If you pay more in tax but
you still take home more money, that's better than paying less in taxes
because you take home less net.
If you have a taxable account and you invest in stocks that you can buy
and hold forever (let's say Berkshire Hathaway, or an ETF like SPY) most
of your taxes are deferred until you sell them 30 years from now. Then,
the earnings are taxed at the long-term capital gains. Assuming capital
gains are taxed at a lower rate than ordinary income, you would be much
better off with your money in a plain old brokerage account rather than
an IRA or other tax-deferred retirement account.

My retirement money is split between a Roth IRA, a 401(k), a traditional
IRA (that I don't contribute to anymore), a margin account at a discount
broker, and some US Savings Bonds. Surely at least /one/ of them will
get favorable tax treatment when I retire.

Best regards,
Bob
 
W

wyu

I decided to google up what RSPP's are but couldn't find anything on
that acronym. However, I was able to find links for RRSP and RPP:

http://financial-dictionary.thefreedictionary.com/Registered+Retirement+Savings+Plan+-+RRSP
http://financial-dictionary.thefreedictionary.com/Registered+Pension+Plan+-+RPP

If this is what we're talking about, sounds like it works similar to
401Ks/IRAs.

In regards to using a VA spreadsheet for calculations, there's a nice
gotcha beyond extra expenses. When I popped the numbers in, I couldn't
make the year 1 numbers match up. In theory, all the different
tax/non-tax accounts should give you the same number if your cashout
time frame is 1 year (assuming all else equal). Looked at the numbers,
cocked my head about 26 degrees and then it became obvious -- pre-tax
money versus post-tax money. E.g. $10K in 401K/IRA or pay 25% tax first
leaving you $7500 for taxable/VA/non-deductible IRA. Using the post-tax
number as your contribution for both pre-tax and post-tax accounts
makes the margin so small, any extra expense can cancel out the
benefits.
 
W

wyu

Popping your proposed case right now into the spreadsheet. Taxable at
15%, 0% turnover. 401K/IRA at 25% tax. And we get the following numbers
after-tax:

10 years: 150K taxable versus 159K tax-deferred
20 years: 517K versus 572K
30 years: 1.44M versus 1.64M

You're probably thinking the numbers don't make sense -- there must be
something wrong with my formulas! How can you pay less tax %, have no
turnover and still come out with a lower number! I actually replied
earlier to Joetaxpayer about the slight little oversight he may have
made -- which also may have slipped your mind. Pre-tax contributions
versus post-tax contributions. You can't just use the same fixed amount
as your yearly contribution for both types of accounts. The amount you
invest in your taxable accounts, reduce by your tax bracket because you
had to pay tax on that money first. Or do the inverse, increase your
401K/IRA money using AMT/(1-tax%).

BTW, the 15% capital gains rate expires in 2011. The odds of it
renewing are low considering the budget deficit. Lots of tax cuts +
spending increases = hard to balance the budget. There's even talk
about trading the tax cuts in return for linking AMT to inflation.
 
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B

Bucky

joetaxpayer said:
Assuming the fees are low, as low as you
could find outside the account, I lean back toward this answer. If the
fees are higher, that pushes me back to my original position.
From what I understand, the RRSP is essentially equivalent to the
Traditional IRA, funded with pre-tax dollars, then the entire amount is
taxed upon withdrawal. If that's the case, that's a huge tax savings
over non-sheltered accounts, much more than potential expense ratio
differences. If you're earning an 7% annual return with a non-sheltered
account, you could be earning 10% return with an RRSP. That's far more
than expense ratio differences.
 

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