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Young investors should pay taxes now, not later

Q: I am 30 and will be getting married this August. Combined, my fiancée and I have $115,000 in Roth IRAs, $53,000 in our 403(b) accounts, $37,000 in taxable accounts, and $10,000 in a variable annuity that we plan not to touch for 40 years.

You recommend that younger investors should pay taxes up front. You suggest contributing as much as possible to Roth IRAs and taxable accounts, while suspending any unmatched contributions to 401(k) or 403(b) plans. At present, our combined modified adjusted gross income is just under the $150,000 limit for full Roth contributions, so we will each continue to contribute to those to the max. If we continue to contribute the maximum at work, our taxable income is right around the top of the 25 percent tax bracket -- $123,700 for 2006.

My question: When a Roth 403(b) option becomes available through our employers next year, should we contribute and stop keeping our income within the 25 percent tax bracket?

B.W.,
Dallas


A: That's exactly what you should do. There are two reasons young workers should pay taxes now rather than later. First, few expect that future income tax rates will be lower than current tax rates. All other things equal, that makes paying taxes now a better deal -- unless your employer is matching. Second, the taxation of Social Security benefits is a minor issue for retirees today, but it will be a major issue for young people when they retire.

The formula for the taxation of Social Security benefits is not indexed to inflation. Fixed at an income measure of $32,000 in 1983, a retired couple with $32,000 of benefits today can have only $16,000 of other income before some of their benefits become subject to taxation.

Have inflation double their benefits to $64,000, and every dime of income from other sources will trigger taxation of Social Security benefits.

At 3 percent inflation, benefits will double in only 24 years. At 4 percent inflation, benefits will double in only 18 years. As a consequence, even if federal tax rates remain unchanged, young workers will face very high marginal tax rates on their tax-deferred savings.

If you want to know who not to vote for, this tax was introduced by Republicans. Later, it was increased by Democrats. So it is a truly bipartisan attack on the young. They made program benefits safe for those who vote today, leaving a major problem for young people.

Q: Every January, I receive a letter from the administrator for my company 401(k) plan. It states that the plan must conduct compliance testing with respect to ``highly compensated" employees --those earning more than $95,000 a year in 2005, and $100,000 in 2006. The IRS says the average percentage of salary contributed by non-highly compensated employees must be compared to highly compensated employees. If the difference is too great, a refund check is issued to the highly compensated employees. In previous years we have passed this test. This year we did not. I received a check for nearly $4,000. So I have to change my 2005 income taxes and contribute less to my retirement this year. Does this happen often? What can my company do to prevent this from happening in future years?

F.M.,
Dallas


A: This happens frequently at companies where the average worker earns relatively little and there is significant turnover. It's particularly galling for workers who earn just enough to be considered ``highly compensated" because the truly highly compensated will be able to max their contributions. Why? Their $14,000 contribution will be a smaller percentage of their income.

You can do two things. If you are married, if your income is under $150,000, and if your spouse is not covered by a plan at work, you can open an IRA and invest the refunded amount there.

The second thing you can do is encourage your employer to provide automatic enrollment and a non-elective employer contribution of 3 percent, or more, of payroll. This will cost real money, but it will avoid top-heavy testing.

Scott Burns is a columnist for the Dallas Morning News. E-mail questions to scott@scottburns.com; fax to 214-977-8776; or mail to Scott Burns, The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265.

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