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Financial Planning > Tax Planning

Public Risk: Taxes

By Francois Gadenne

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Discussions of consumer spending tend to focus on post-tax dollars. This can be misleading because taxes are likely to be the bigger and faster growing expense category for employees in general and retirement investors in particular. When it comes to analyzing expenses and budgets many authors and analysts seem to suffer from “tax myopia.” Taxes are the “elephant in the room.”

The concept of stress tolerance can help us understand when and why a retirement plan might fail by not helping the retiree’s productive adaptation to change. As Paul Ormerod shows in his book Why Things Fail, stress tolerance can be seen as a threshold, above which a person or a system fails. The transition from doing well to failing can be quite abrupt. When the external stress is below the investor’s stress tolerance level, the investor does well. However, once the external stress level increases, even just a little above the investor’s tolerance level, failure occurs.

The destructive power of taxes on income and investments is likely to be felt more painfully by retirees than by employees who are still in their accumulation phase. Also, the stress tolerance of older investors is likely to be much lower than the stress tolerance of younger investors. Retirees are more likely to be on a fixed income. Retirees have fewer years left to make up for errors. While some may have hedged their inflation risk with COLAs and TIPS, how would you hedge your tax risk?

There are many types of taxes. Taxes come in a wider variety of forms than many of us expected when we were growing up, including federal income tax, Social Security tax, Medicare tax, state income taxes, state sales taxes, real-estate taxes, city income taxes, municipal excise taxes, etc. Taxes are levied on income as well as assets. Taxes are levied on realized capital gains as well as, amazingly enough, on unrealized capital gains (i.e., real estate taxes). Income taxes have even been levied retroactively.

Taxes Vary With Location As shown by a recent report, “Tax Rates and Tax Burdens in the District of Columbia: A Nationwide Comparison,” total state tax burden can vary by a factor of 1 to 6. For example, households with an annual income of $150,000 in 2005 would have paid average state taxes from all sources of about $4,000 in Alaska versus $24,000 in Connecticut.

Ben Williams, co-founder of the firms Rational Investors and Retirement Engineering, points out that local governments and municipalities may create even larger retirement planning risks for investors and retirees than the federal government. Municipalities have less fiscal and debt flexibility when they run into problems. Raising taxes becomes the default action. Unaccounted liabilities, such as pension and health benefits for municipal employees, are less researched and less publicly known than the federal problems with earmarks, entitlements, Social Security and Medicare.

The magnitude of these local impacts on an individual is likely to be higher than the federal impacts in many ways, not the least of which will be lowering the value of housing by the amount of the net present value of increased property taxes. Local tax increases will not only affect discretionary income, they will also affect asset values.

Rates Change Over TimeUsing the very same data from a book written by two academics (Elizabeth Warren and Amelia Tyagi), The Two-Income Trap, Todd Zywicki at the blog The Volokh Conspiracy shows a clear example of “tax myopia” by taking taxes into explicit consideration, thus reversing the book’s findings. His analysis shows that the average single income family in the early 1970s had more discretionary income as a percent of their budget (46 percent) than the average dual-income family in the early 2000s (25 percent). In contrast to the conclusions of The Two-Income Trap, he shows that this not caused by rising health, mortgage and automobile costs but rather by rising taxes (from 24 percent of budget to 34 percent of budget).

“Overall,” Zywicki writes, “the typical family in the 2000s pays substantially more in taxes than in their mortgage, automobile expense, and health insurance costs combined. And the growth in the tax obligation between the two periods is substantially greater than the growth in mortgage, automobile expense, and health insurance costs combined.” While we worry about health care costs in retirement, should we not worry even more about taxes?

Taxes Are Stressful Changing tax rates and higher tax payments, as a percent of the affluent and high-net-worth retirees’ budget, bring great uncertainty in retirement planning. One could argue that tax payments may be more rather than less likely to increase over the remaining life of a retiree unless something is done to reduce Congress’ spending habits. Governmental institutions, like investors and retirees, are exposed to spending risk. Given how fast income taxes have grown since their creation at the beginning of the 20th century, Congress, most states and some municipalities have shown greater exposure to spending risk and less spending discipline than individual investors and retirees.

Spending control is unlikely as shown in a presentation by the Comptroller General of the United States, “U.S. Financial Condition and Fiscal Future Briefing:” Mandatory spending programs represent 53 percent of federal spending, and another 9 percent goes to net interest payments on the national debt. Only 38 percent of federal spending is discretionary. Spending discipline can only be applied to discretionary spending. Taxes feel like a one-way ratchet, unless we start cutting down entitlements. At this point in time, unless the mood of the voters changes, all indications are that taxes will keep going higher and higher and will be paid by fewer and fewer people.

Taxes Polarize This lack of spending discipline creates great retirement planning uncertainty because data from the “Overview of the Federal Tax System as in Effect for 2008,” authored by the staff of the Joint Committee on Taxation, show that a shrinking minority of citizens pays most of Congress’ bills:o The top 1 percent of taxpayers pays almost 40 percent of all income tax.o The top 10 percent pays about 70 percent.o The top 50 percent pays nearly 97 percent.

As the vernacular expression has it, taxes have the power to “kill the goose that laid the golden egg.” A recent “Special Report: Who Pays America’s Tax Burden, and Who Gets the Most Government Spending?” by the Tax Foundation shows that the bottom 60 percent of households receive more in government spending than they pay in taxes. This means that a majority of citizens may be net beneficiaries of government redistribution programs, and a decreasing minority of citizens are actual taxpayers. This imbalance continues to grow over time and it is likely to threaten social cohesion, adding more uncertainty for retirees.

Comprehensive retirement plans that cannot anticipate the true behavior of tax rates and tax payments over the planning horizon are likely to create a lot of stress for the retiree. The more comprehensive the plan, the less flexible to changes it may be. Insufficiently frequent updates may cause plan failure by creating real and psychological stress levels (e.g., insufficient income flexibility or invalidated withdrawal expectations) that the retiree cannot bear in the face of escalating tax payments.

This suggests that, to fulfill its purpose and to limit the odds of plan failure, a retirement planning process needs to iterate solutions and recommendations. Such iterations can take place across account types (i.e., taxable, tax-deferred, tax-free) as well as over time. Time-based iterations could take place on an annual basis and focus on incremental allocations to risk management approaches (i.e., diversified risky assets, insurance guarantees, exposure-transforming options and hedges) as well as decisions about human and social capital assets. How often do you update your clients’ retirement plan? How much flexibility have you built in the plan in order to make adjustments?

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Francois Gadenne is chairman and executive director of the Retirement Income Industry Association in Boston; see www.riia-usa.org.

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