IRA analysis with Visicalc. R. A. Dousette.
The Economic Recovery Act of 1981 permits individuals covered under tax qualified pension plans to set up their own Individual Retirement accounts. An individual may contribute up to $2000 (not to exceed 100% of gross income) to an IRA and deduct the amount from his income. Any amount withdrawn from the account must be counted as taxable income in the year of withdrawal, and, if the money is withdrawn before age 59 1/2, the IRS imposes an additional 10% penalty.
The Act, signed into law by President Reagan on August 31, 1981, has been described as the biggest tax cut in history. Those who set up an IRA have two advantages. Taxation on the IRA contributions can be deferred until retirement (presumably taxes will be lower then), and the interest earned by the IRA isn't taxable until withdrawn.
The latter of the two is of more value than it might seem at first glance, because the taxpayer retains the interest that would otherwise have been paid to the IRS, and because this interest accumulates and earns more tax-sheltered interest.
In my case, I was a bit reluctant to set up an IRA because of the 10% penalty on early withdrawal. I am far from age 59 1/2 (not as far as I would like), and I wasn't sure that the tax advantages would compensate for the loss of liquidity.
What should I do? VisiCalc to the rescue. I designed a spreadsheet that predicts when the tax advantage overtakes the penalty for various combinations of interest rates and tax rates.
The spreadsheet, shown in Figure 1, is divided into three sections. The first section assumes that no IRA is set up, and then calculates the cash available at the end of each year. Interest is earned on the principal each year based on the assumed rate, and the tax is paid at the end of the year based on the marginal tax rate.
The second section illustrates the effects of setting up an IRA. There are two funds: the tax-sheltered IRA fund in which interest isn't taxed, and a second fund in which it is. The second fund represents an accumulation of the tax savings that arise from setting up the IRA.
The third section compares the cash available at the end of each year from the first two sections.
The VisiCalc commands for creating the worksheet are shown in Figure 2. Explanations of the entries are also given.
The worksheet shows that if 15% interest can be earned, the tax advantages of the IRA exceed the 10% penalty in only five years for those in the 30% tax bracket. By entering different tax brackets it can be shown that the same five year advantage applies to those in the 40% and 50% tax brackets.
What if the average yield on investments is 12% over the next several years? Those in the 30% to 50% marginal tax range will find that the IRS comes out ahead in the sixth year; if the marginal tax rate is 20%, the IRA exceeds the 10% penalty in eight years. A further decline in yield to 8% adds about another two years to the time required for the IRA to move ahead.
It would seem, then, that for most taxpayers who can set aside some money for the next six to eight years, the 10% penalty on termination is a threat without teeth. So, if setting up an IRA in 1982 is such a good idea, why not do it again in 1983? Or in 1984?
Figure 3 shows an IRA illustration in which $2000 is invested in each of the succeeding years. This worksheet can be derived from the Figure 1 worksheet by entering the commands shown in Figure 4.
The new worksheet assumes that the taxpayer invests an amount each year that, with the prior year's tax refund, totals a $2000 contribution to the IRA. Thus, in the first section of the worksheet, the investments after 1982 are the same as the additional investment needed under the IRA.
There is no need for a fund to accumulate the tax refund in the second section, because the tax refund is used to reduce the next IRA contribution.
In the third section, the total cash available with the IRA is equal to the IRA fund reduced by taxes and the penalty and increased by the tax refund on the last contribution.
As in the other worksheet, the number of years required for the IRA to move ahead can be determined by entering different marginal tax brackets and interest rates. For those in a 30% tax bracket, the IRA moves ahead in ten years if 12% is earned on the fund, and in eigth years if 15% is earned. Those in 40% and 50% tax brackets will be ahead with an IRA in nine years if 12% interest is earned, and in seven years if 15% is earned. Those in a 20% tax bracket will have to wait ten years if they can earn 15% interest; at 12% interest, they must wait 12 years.
What about those unfortune (or clever) enough to be in a 10% tax bracket? If the interest earned is 15%, the IRA will break even in 15 years. If interest earnings are 12%, 18 years are required to break even. If only 8% is earned over the next several years, then it will be more than 20 years before the IRA moves ahead. Obviously, the higher your taxes, the more you benefit from tax breaks.
The worksheets contain several simplifying assumptions that other users may want to modify. For example, they assume that the IRA investments are made exactly one year before the tax refund is received; in actuality, the tax refund could be received much sooner by adjusting the tax withheld from pay. Also, tax rates and interest rates can change in the future.
However adjusted, the conclusion should remain that an IRA is an excellent investment for those who can relinquish the liquidity of their assets for a few years.