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March 2014 Volume 3, Issue 3 INVESTMENT SOLUTIONS THAT FIT TODAY’S GLOBAL ECONOMY Should Investors Delay the Tax Bite? Uncle Sam sometimes gives taxpayers a choice: Pay me now or pay me later. Investors can sock away a portion of their savings in tax-deferred investment vehicles—traditional IRAs, Roth IRAs, 401ks, 403bs, Simplified Employee Pension (SEP) plans, Keoghs, fixed and variable annuities and the like. Financial advisors usually urge clients to take advantage of these tax breaks, often to the max. Delaying taxes is usually a good deal. Just how good depends on investment returns, current tax rates, anticipated future tax rates and years until retirement. To show how these factors interact, we conjure up a 21st Century Adam Smith. He’s 26 years old, a Harvard-educated lawyer earning enough to put him in the top tax bracket. Smith needs to decide whether to defer taxes on his retirement savings. Tax Rates, Returns and Time Smith projects an annual return of 8 percent—close to the long-term average for U.S. stocks. Facing a marginal tax rate of 40 percent, each $1,000 he puts in a tax-deferred account would save him $400 in current taxes but create future tax liabilities. Smith wants to see how the after-tax value of $1,000 would grow when sheltered from taxes—if he faces lower tax rates in retirement. After 41 years— Smith will be 67—he’d have $17,597 after taxes if he anticipates an income tax rate of 25 percent in retirement ( see chart below ). Smith worries about the federal government’s huge fiscal deficits and unfunded promises. Future taxes may be higher, not lower, especially for wealthy Americans. If Smith continues to pay taxes at a 40 percent marginal rate into his retirement, his after-tax gain would be reduced to $14,077. How does this compare with a scenario where Smith pays taxes on his savings every year? The tax bite starts with his current income at 40 percent, reducing his initial investment to $600. Each year, he’d pay the taxes due on his investment income—40 percent if earned as interest or non- qualified dividends, a 20 percent base plus 3.8 percent Medicare surcharge if earned as qualified dividends By W. Michael Cox and Richard Alm Small Talk Bankrupt nation. Boston University economist Laurence Kotlikoff estimates America’s true national debt at $205 trillion. He starts with the $12 trillion in existing debt in the hands of the public. Then he adds up all the future obligations to pay for Social Security benefits, Medicare, Medicaid and the routine functions of government. Projected tax revenues fall 60 percent short, leaving the nation $205 trillion in the hole. The government disguises this massive debt with accounting fraud far worse than anything perpetrated by Bernie Madoff or Enron. “So the country really is bankrupt and nobody sees it because of the bookkeeping,” Kotlikoff said. Regulatory beat. Using the Internet to help startups raise capital, equity crowdfunding gives small investors a chance to get in on the ground floor of what might be the Next Big Thing. The Securities and Exchange Commission proposes to limit the size of investments, mandate specific disclosures and require SEC-registered intermediaries.To raise between $500,000 and $1 million, fees and compliance costs would range from $76,660 to $151,660. “The SEC must avoid costly, paternalistic requirements on crowdfunding that have the effect of keeping the status quo and locking ordinary investors out of startup capital,” said John Berlau, senior fellow for the Competitive Enterprise Institute. Borrowing again. The financial crisis battered American households and left them leery of debt. According to the Federal Reserve Bank of New York, total household debt peaked at nearly $12.7 trillion in the third quarter 2008. In subsequent quarters, Americans owed less than they did a year earlier—a pattern that held for the next five years. Now, the great deleveraging has ended—at least temporarily. With households willing to buy cars and houses and use their credit cards, debt surged $241 billion in last three months of 2013, creating a four-quarter increase of $180 billion in outstanding debt. Total household debt was $11.5 trillion. Fed Watch and Chart Topper: Page 3 Continued on page 2 Source: Authors’ calculations $4,000 $14,000 $16,000 $2,000 $18,000 $12,000 $8,000 $10,000 $6,000 0 5 10 15 20 25 30 35 40 $0 Initial Investment of $1,000, 8% Annual Rate of Return Defer Taxes Pay as You Go $17,597 $14,077 $8,904 $6,789 15% Tax Rate on Capital Gains 23.8% Tax Rate on Capital Gains 40% Tax Rate in Retirement 25% Tax Rate in Retirement After-Tax Value at the End of N Years Longer Time Horizons, Lower Taxes Magnify Gains from Deferring Taxes To learn more about deciding whether to defer taxes, use our calculator: http://argentusoutlook-66096.hibustudio.com/newsletter/1238573

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Page 1: THEARGENTUS OUTLOOK - The McGowanGroup · 2019-11-05 · startups raise capital, equity crowdfunding gives small investors a chance to get in on the ground floor of what might be

March 2014 • Volume 3, Issue 3

INVESTMENT SOLUTIONS THAT FIT TODAY’S GLOBAL ECONOMY

THEARGENTUS OUTLOOK

Should Investors Delay the Tax Bite?Uncle Sam sometimes gives taxpayers a choice: Pay

me now or pay me later. Investors can sock away a portion of their savings in tax-deferred investment vehicles—traditional IRAs, Roth IRAs, 401ks, 403bs, Simplified Employee Pension (SEP) plans, Keoghs, fixed and variable annuities and the like.

Financial advisors usually urge clients to take advantage of these tax breaks, often to the max. Delaying taxes is usually a good deal. Just how good depends on investment returns, current tax rates, anticipated future tax rates and years until retirement.

To show how these factors interact, we conjure up a 21st Century Adam Smith. He’s 26 years old, a Harvard-educated lawyer earning enough to put him in the top tax bracket. Smith needs to decide whether to defer taxes on his retirement savings.Tax Rates, Returns and Time

Smith projects an annual return of 8 percent—close to the long-term average for U.S. stocks. Facing a marginal tax rate of 40 percent, each $1,000 he puts in a tax-deferred account would save him $400 in current taxes but create future tax liabilities.

Smith wants to see how the after-tax value of

$1,000 would grow when sheltered from taxes—if he faces lower tax rates in retirement. After 41 years—Smith will be 67—he’d have $17,597 after taxes if he anticipates an income tax rate of 25 percent in retirement (see chart below ).

Smith worries about the federal government’s huge fiscal deficits and unfunded promises. Future taxes may be higher, not lower, especially for wealthy Americans. If Smith continues to pay taxes at a 40 percent marginal rate into his retirement, his after-tax gain would be reduced to $14,077.

How does this compare with a scenario where Smith pays taxes on his savings every year? The tax bite starts with his current income at 40 percent, reducing his initial investment to $600.

Each year, he’d pay the taxes due on his investment income—40 percent if earned as interest or non-qualified dividends, a 20 percent base plus 3.8 percent Medicare surcharge if earned as qualified dividends

By W. Michael Cox and Richard AlmSmall Talk • Bankrupt nation. Boston University economist Laurence Kotlikoff estimates America’s true national debt at $205 trillion. He starts with the $12 trillion in existing debt in the hands of the public. Then he adds up all the future obligations to pay for Social Security benefits, Medicare, Medicaid and the routine functions of government. Projected tax revenues fall 60 percent short, leaving the nation $205 trillion in the hole. The government disguises this massive debt with accounting fraud far worse than anything perpetrated by Bernie Madoff or Enron. “So the country really is bankrupt and nobody sees it because of the bookkeeping,” Kotlikoff said.

• Regulatory beat. Using the Internet to help startups raise capital, equity crowdfunding gives small investors a chance to get in on the ground floor of what might be the Next Big Thing. The Securities and Exchange Commission proposes to limit the size of investments, mandate specific disclosures and require SEC-registered intermediaries.To raise between $500,000 and $1 million, fees and compliance costs would range from $76,660 to $151,660. “The SEC must avoid costly, paternalistic requirements on crowdfunding that have the effect of keeping the status quo and locking ordinary investors out of startup capital,” said John Berlau, senior fellow for the Competitive Enterprise Institute.

• Borrowing again. The financial crisis battered American households and left them leery of debt. According to the Federal Reserve Bank of New York, total household debt peaked at nearly $12.7 trillion in the third quarter 2008. In subsequent quarters, Americans owed less than they did a year earlier—a pattern that held for the next five years. Now, the great deleveraging has ended—at least temporarily. With households willing to buy cars and houses and use their credit cards, debt surged $241 billion in last three months of 2013, creating a four-quarter increase of $180 billion in outstanding debt. Total household debt was $11.5 trillion.

Fed Watch and Chart Topper: Page 3

Continued on page 2

Source: Authors’ calculations

$4,000

$14,000

$16,000

$2,000

$18,000

$12,000

$8,000

$10,000

$6,000

0 5 10 15 20 25 30 35 40$0

Initial Investment of $1,000,8% Annual Rate of Return

Defer Taxes

Pay as You Go

$17,597

$14,077

$8,904

$6,78915% Tax Rateon Capital Gains

23.8% Tax Rateon Capital Gains

40% Tax Ratein Retirement

25% Tax Ratein Retirement

After-Tax Value at the End of N Years

Longer Time Horizons, Lower Taxes Magnify Gains from Deferring Taxes

To learn more about deciding whether to defer taxes, use our calculator:

http://argentusoutlook-66096.hibustudio.com/newsletter/1238573

Page 2: THEARGENTUS OUTLOOK - The McGowanGroup · 2019-11-05 · startups raise capital, equity crowdfunding gives small investors a chance to get in on the ground floor of what might be

or capital gains. At 23.8 percent, the after-tax value of Smith’s $600 would be $6,789 at the end of 41 years—a bad deal compared to the tax-deferred plan.

Until 2013, the tax rate on long-term capital gains and qualified dividends was 15 percent. At 41 years, raising the tax rate to 23.8 percent reduced the after-tax value of each $1,000 from $8,904 to $6,789.

For each $1,000 held 41 years, not deferring taxes cost Smith $10,808 at the 25 percent tax rate and $7,288 at the 40 percent tax rate. A quick calculation reveals Smith’s average annual after-tax returns—7.25 percent for the tax-deferred account, 4.78 percent for the pay-now approach.To Defer or Not Defer

No fool with money, Smith decides to put his savings into a tax-deferred account—not just that first $1,000 but many additional $1,000s, every year throughout his legal career. He expects to retire with a nest egg of millions of dollars.

The exercise taught Smith some valuable lessons. The payoff from delaying the tax bite will increase with higher tax rates on current income, lower tax rates on retirement income or higher investment returns.

Perhaps most important, Smith came to appreciate the miracle of compound interest—the great value of time in reaping rewards from tax-deferred investing. At a 25 percent tax rate in retirement, the gap between deferring taxes and paying 23.8 percent each year widened with each passing decade—$535 at 10 years, $1,536 at 20 years, $4,006 at 30 years and $10,808 at 41 years.

Can our Adam Smith ever find it better to pay taxes now rather than delay them? It’s not likely on wage and salary income facing the top marginal rate—the initial tax hit’s just too big. The answer’s different if the initial funds come not from income but from assets not

burdened by tax liability.If Smith’s considering shelter these assets’ future gains

through a tax-deferred plan, he’ll face a tradeoff between the pay-now tax rate and his time horizon (see chart below ). Shorter time horizons and lower tax rates favor paying taxes every year (orange area ). The decision shifts toward deferring taxes when money has more years to grow and capital gains taxes go up (green area ).

At various combinations of tax rates and years, the choice between paying Uncle Sam now or later would be a coin flip—if Smith’s annual rate of return stays at 8 percent (arced line ).

Now, Smith can see another impact of the recent hike in the long-term capital gains tax. At the 15 percent rate, it took 19 years for deferring taxes to gain an edge over paying annually. Now that he’s taxed at 23.8 percent, deferring taxes will start to pay off in just two and a half years.

A final thought. Most portfolios include a variety of financial assets—stocks, bonds, mutual funds, etc. For tax purposes, some holdings are short term and taxed as regular income at 40 percent, some are long term and taxed as qualified dividends and capital gains at 23.8 percent. This complicates the calculation of an investment tax rate.

Suppose Smith holds only growth stocks that pay no dividends and takes his gains every 10 years, paying taxes at 23.8 percent. His equivalent annual tax rate would be 18.3 percent. Now, suppose Smith derives his investment income in equal thirds from interest, dividends and capital gains. Half of the dividends and capital gains are short term, facing the 40 percent rate. His equivalent annual tax rate would be 33.8 percent.

Continued from page 1

THE ARGENTUS OUTLOOK

About Michael Cox W. Michael Cox is director of the William J. O’Neil Center for Global Markets and Freedom at Southern Methodist University’s Cox School of Business. He is chief economic advisor to Argentus Partners, LLC.

What It Meansfor Your Clients

Richard AlmRichard Alm is writer in residence at the William J. O’Neil Center for Global Markets and Freedom at Southern Methodist University’s Cox School of Business

By breaking down the influences of

investment returns, today’s tax rates,

tomorrow’s tax rates and investment time

horizons, Dr. Cox adds some important

nuances to decisions about tax-deferred

investing.

For example, it will pay off even if your

clients don’t face lower tax rates in their

retirement years. That’s good to know.

It’s no longer safe to assume that the U.S.

government won’t raise tax rates in the

future—with wealthy households the likely

target for tax hikes.

Another important conclusion: the

case for putting off taxes has become

even stronger now that the government

no longer taxes qualified dividends and

capital gains at just 15 percent. Once

again, that’s good to know. By April 15,

many of your clients will be filing their first

federal income tax returns subject to the

23.8 percent rate.

For the most part, tax-deferred investing

has been synonymous with 401k plans

and similar accounts. Not all your clients

will have the option of saving in a 401k;

others’ saving needs may exceed the

annual limits on 401k contributions.

The financial industry offers a variety

of ways to meet their needs. For example,

your clients might consider putting after-

tax money into fixed or variable annuities

that delay the tax bite. Today’s higher

capital gains tax rates may make investors

more receptive to this option.

Among fixed annuities, indexed

products are better than traditional ones

in today’s market, where interest rates

have nowhere to go but up. In some cases,

annuity balances are protected from the

claims of creditors, another advantage

over other forms of savings.

By Argentus Partners, LLC

With Higher Capital Gains Taxes, Deferring Money Makes More Sense30%

5%

25%

15%

20%

10%

0 5 10 15 20 25 30 35 400%

At an 8% rate of return and a capital gains tax rate of 23.8%, you’re better off investing inside a tax-deferred plan if your time horizon exceeds 2½ years.

Source: Authors’ calculationsYears of Tax Deferment

At an 8% rate of return and capital gains tax rate of 15%, you’re better off paying taxes as you go if your time horizon is less than 19 years.

Better Off Being in a Tax-Deferred Investment Plan

Better Off Paying Taxes As You Go

Capital Gains Tax Rate

Page 3: THEARGENTUS OUTLOOK - The McGowanGroup · 2019-11-05 · startups raise capital, equity crowdfunding gives small investors a chance to get in on the ground floor of what might be

W. Michael Cox’s Fed Watch:

For years now, the Federal Reserve has tried to fuel growth and reduce unemployment by keeping interest rates low and pumping money into the economy through securities purchases. The policies haven’t delivered as promised, largely because banks chose to hold excess reserves rather than make loans.

You could say shame on the banks—but the Fed brought this upon itself. It made four policy mistakes that contributed to the banks’ hunkering down.

First, the Fed started paying interest on reserves. Lending offers low interest rates and high risks. Holding reserves allows banks to make low returns without taking any risks.

Second, the Fed heaped on added bank regulation, often taking its sweet time. The new rules raised costs of lending, and the delays created uncertainty in an

already wary financial services industry.Third, driving interest rates down contributed to a

“liquidity trap,” sapping the effectiveness of traditional monetary policy tools. In the trap, interest rates can’t go any lower, and lenders hang back and wait for them to rise back to normal levels.  Fourth, the Fed helped big banks get bigger. While small banks were allowed to fail in the financial crisis, government policy protected the biggest banks through bailouts and mergers. The four largest banks now have 41 percent of depository industry assets, up from 38 percent in 2007. When big banks gobble up more assets, small business lending suffers, depriving the economy of a spark (see Chart Topper below ).

Early on, the economy didn’t respond to the flood of money, but the Fed failed to see the error of its ways. It

just kept making the same mistakes again and again, culminating in the $85 billion a month in quantitative easing during 2012 and 2013. Even today, the Fed persists in these policies.

It would be bad enough if the Fed’s misguided policies merely held back economic activity and job growth. But they created an even bigger potential problem, one that will haunt the central bank this year and beyond. The policies of the past five years have left the banking system awash in excess reserves, greatly increasing the risks of higher inflation and interest rates.

In 25 years at the Federal Reserve Bank of Dallas, Dr. Cox rose to chief economist and senior vice president, advising the bank’s president on monetary policy and other economic issues.

Chart Topper

About The Argentus OutlookA monthly publication of Argentus Partners, LLC, the newsletter strives to deliver current economic information relevant to investing and operating in today’s complex global economy.

Chief Executive Officer: Douglas Gill, CFP®Publisher: Susanna Joiner, Chief Marketing OfficerEditor: Richard AlmContact: [email protected]

THE ARGENTUS OUTLOOK

Too Big to Lend Small: Largest Banks Could Be Doing More for Small BusinessesSmall businesses borrow for a variety of reasons—to

invest in new facilities, modernize equipment, buy inputs, raise working capital, refinance debt. More often than not, they turn to small business loans, a category covering transactions up to $1 million.

At America’s biggest banks, the reception has been chilly. The four largest banks—JP Morgan Chase, CitiBank, Bank of America and Wells Fargo—have 41 percent of all depository industry assets but make just 21 percent of small business loans. Most of the credit that fuels small businesses’ expansion comes from the nation’s 6,000-plus smaller financial institutions, notably the American Express bank.

Rather than lending to small businesses, the banking behemoths are concentrating on other financial services, presumably ones they find more profitable. Since the financial crisis in 2008, for example, the biggest banks credit-card operations have been surging.

Fearing big bank failures would cripple the economy, policy-makers doled out billions in government aid during the financial crisis. Critics gave these banks a disparaging moniker—Too Big To Fail. By not making their share of small business loans, the giant financial institutions may also be Too Big to Lend Small.

60

70

100

20

90

10

80

40

50

30

0 10 20 1000

Source: Federal Deposit Insurance Corp.

30 40 50 60 70 80 90

Percent of Small Business Loans

Wells Fargo

Bank of America

CitiBank

JPMorgan Chase

Share of Small Business Loans EqualsShare of Assets Along Diagonal Line

Percent of All Depository Industry Assets

American Express, FSB

Page 4: THEARGENTUS OUTLOOK - The McGowanGroup · 2019-11-05 · startups raise capital, equity crowdfunding gives small investors a chance to get in on the ground floor of what might be

Important Disclosures: Information herein in this newsletter and has been obtained from sources believed to be reliable, but its accuracy and completeness cannot be guaranteed. This newsletter is for informational purposes only, and should not be considered as an offer, invitation or solicitation to subscribe, purchase or sell or any securities, and is not intended to provide any specific investment advice or recommendation. You should review your personal financial situation, investment objectives, goals and risk tolerance prior to investing. All indices referenced are unmanaged and an investor cannot invest directly into any index. The economic forecasts and projections illustrated in the newsletter may not develop as predicted and there can be no guarantee or assurance that strategies promoted will be successful. All expressions of opinion reflect the judgment of Dr. Cox and his research conducted for Argentus Partners, LLC at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete.

This research material has been prepared by Argentus Partners, LLC. To the extent you are receiving investment advice from a separately registered independent investment advisor, please note that Argentus Partners, LLC is not an affiliate of and makes no representation with respect to such entity.

THE ARGENTUS OUTLOOK

For additional information, or to subscribe to the monthly publication,please e-mail [email protected]