Tuesday, March 15, 2011

Is the 401(k) unfair to poor people? (YES)

A huge experiment is going on in America right now, and the results will come out in about 5-10 years.  An entire generation of Americans is expected to retire on their savings in their 401(k) or IRA.  If you are wealthy, this will work out well for you.  If you are poor, go fuck yourself.

As I noted in my Progressive Tax posting, our tax system is designed to be progressive, in that the marginal rates increase as your income increases.  Even with the "Bush Era Tax Cuts" the people in the highest margins can pay as much as 35% marginal rates, while most "middle class" Americans are in the 15 or 25% rate scale.

This means that the rich pay more taxes, as a percentage of income, as they make more money.  But it also means that deductions become more attractive as their income increase.  The home mortgage interest deduction, as I illustrated earlier, is lucrative to someone in the 33% bracket, but worth half as much to someone in the 15% bracket.

And as I illustrated in that example, because of this, the person who makes more money can buy a more expensive house than a poorer person and end up with the same effective monthly mortgage payment as they "get back" more in taxes.  So if someone in the 15% bracket spends $1000 a month on a mortgage, it buys a lot less house than the person in the 25% or 35% bracket could - for the same monthly payment.

The rich get richer and the poor get poorer, and our "progressive tax system" works against the poor in that regard.

And the same is true with the 401(k).  If you put money into your 401(k) it is tax-deferred.  This means you pay no tax when you put money into the plan, only when it is withdrawn later in life.  As we learned in tax law class (after a blackboard full of calculations) the net effect of this tax deferral is that you get an increase in gain equal to your marginal rate.  It is a pretty sweet deal and you should put money into it, particularly when you are young.

But if you poor or lower middle class (which could mean a combined income of up to $68000) you are probably in the 15% tax bracket.  The tax savings of putting money into a 401(k) are pretty small - it may not even be higher than your standard deduction.  And since 401(k) limits are based in part on percentage of income, chances are, you can put away less, too.  But that point is moot, as if you are poor, chances are, you can't afford to put away much, as you have to spend most of your income on living expenses.

(And of course, the poor, as I have noted in the past, tend to squander their money on the bad bargains presented to them, but let's take aside that argument for the time being).

Meanwhile, if you are in the higher brackets (25% to 35%) you get a much larger deduction on your taxes as a result of your contribution.  Which effectively means, you can get a bigger bang for your buck than the poor schmuck in the 15% bracket.

Let's use an example.  Joe and Tim work at a law firm.  Joe works in the copy room, making copies, and he and his wife make a combined income of $50,000 a year.  Not bad, and about the median income in America.  They are in the 15% bracket.  It takes a lot of hard work, but they put away $10,000 into their 401(k) every year.  This reduces their effective income by $10,000, so they save $1500 on their Federal taxes.  Thus, in effect, for a $8500 investment, Joe has $10,000 in his 401(k).

Tim, on the other hand, is a young Associate at the firm, with a bright future, making over $100,000 a year in combined income with his wife, which they spend on a nice house and fancy cars.  They decide to put $10,000 into their 401(k) plan, which is a lot easier for them to do than it is for Joe.  Since Tim is in the 25% bracket, this knocks $2500 off his Federal income taxes.  Thus, in effect, for a $7500 investment, Tim has $10,000 in his 401(k).

Or, if we look at this another way, if both Joe and Tim put away the same effective amount of money, taking into account the tax effect,  Joe would have to put in $8695.62 to get $10,000 in his 401(k) while Tim needs only to put away $8000 even.  Which is good for Tim, as that $695.62 comes in handy when you spend $10 a day on coffee drinks, as Tim does.

So in other words, the progressive tax brackets end up as a sop to wealthier people, making it easier for them to save money - giving them a larger tax boost for contributions to IRA, 401(k) and other tax-deferred plans.

But what about the other end of the deal?  When they retire?  Well for Joe, the tax break isn't as great.  He paid in when he was at the 15% rate, and chances are, unless he retires destitute or the tax rates radically change between now and then, Joe will withdraw his 401(k) and pay taxes at the 15% rate.  Joe gets the real advantage of tax deferment, but does not get the advantage of paying taxes in a lower bracket.

Tim, on the other hand, retires with two homes that are "paid for" and structures his income in annuities and insurance and other vehicles such that his income is now in the 15% bracket.  He can live comfortably on a middle-class salary at this point in his life.  He takes money out of his 401(k) that he paid in while at the 25% marginal rate, but pays taxes now at the lower rate of 15%.  Tim gets the advantage of tax deferment, AND gets the advantage of paying taxes in a lower bracket!

The rich get richer, eh?

Now of course, you might argue that the system is "fair" overall, as Tim has to pay those high marginal rates, and as his income rises, he will end up in the 28%, 33% or maybe even 35% brackets and pay a lot more taxes!

But as we noted before, part of this is offset by the fact that Tim stops paying social security tax which is 6.5%,  on any monies he makes over $108,000 or so.  So while he may be paying more in Federal Income tax, his Social Security tax drops.  And in fact, at that "sweet spot" between $108,000 and $137,000 (at the time of this posting) the effective marginal rate decreases because of this effect.

When Tim makes partner and starts making "real money" he can afford to hire an accountant and take advantage of all sorts of legitimate tax deductions out there (not "loopholes" as some folks call them) that require a lot of money to use.  So his effective marginal rates may be even lower, if he, for example, has some depreciating assets he has invested in, such as Real Estate, that can knock his Federal tax bill down considerably.  And yea, he has to pay that back later on, but at lower Captial Gains rates, not ordinary income rates.

Now let's get back to those "taking aside" arguments I mentioned earlier.  In reality, Joe would be hard pressed to put aside $10,000 a year on his salary of $50,000 a year.  Such saving (20% of income) are near-heroic, particularly at that income level - unless Joe can live rent-free with his Mother.  So the reality is, Joe will likely save a lot less.

And if Joe is like most of the middle-class schmucks in this country (raise your hands!  I'm one, too!) he probably blows a lot of his dough on dubious things like Jet Skis, shiny rims for his car, Cable TeeVee, and other junk, which means he likely puts NOTHING in his 401(k), or very little at best.

So... what's the answer to all of this?  From a policy standpoint?  From a personal standpoint?

For the former, I am not so sure, as major changes in our tax policies are talked about, but would be difficult to implement.  And making radical changes often causes more harm than good.  The 401(k), like the home mortgage interest deduction, is a 30-year process for people, and changing the rules in the middle of the game - a game the government has induced us all to play - is very unfair.

And it goes without saying that eliminating our progressive marginal rates might solve these deduction problems, but would create a whole different set of problems - and in fact increase taxes on the lower classes.  A flat tax sounds fine, in theory, until you realize, as a poor person, it means your tax bill might double, while a rich persons might drop in half.

Changing the Rules for 401(k) plans or the Home Mortgage Interest Deduction would leave most taxpayers in this sort of situation.  They have been induced to play the game.  Taking away the football at the last moment would be cruel.

So that just leaves the latter.  What you can do to protect yourself.  Railing about the "unfairness" of the tax code doesn't help your immediate bottom line.  Spending less on junk and putting money aside in a diversified portfolio does.  So while it is all very well and good to understand the nature of the problem (as opposed to chanting slogans and holding signs) the upshot is still that you have to take personal responsibility and do the best you can, even in a situation that is arguably "unfair".