Lifetime Planner IDEA: Calculate Tax on Salary based on 401k or IRA Deductible Contributions

Scooterlam
Scooterlam SuperUser, Windows Beta Beta
Lifetime Planner IDEA:  Calculate Tax on Salary based on 401K or IRA Deductible Contributions


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The current tax model in Quicken Lifetime Planner (LTP) does not calculate tax on salary based upon 401K or IRA deductible contributions.   That is, LTP applies the tax rate setting to the "Total Salaries" amount, regardless of any tax-deferred, deductible contributions. 

For 401k and to a lessor degree IRA savers, this can result in a substantial under forecast of final plan balance.



THE CHANGE


1.   Modify the current tax model in LTP to factor in 401K or IRA deductible contributions when calculating "tax on salaries".   That is,

(Salary - Deductible Contribution) * Tax Rate


2.   Implement a strategy to avoid "excess deduction" when the plan participant (and/or spouse) contributes to BOTH a workplace 401k plan (deductible) and a traditional IRA (non-deductible).


3.   Review and modify tax model for other applicable, Quicken tax-deferred account types, other than IRA and 401K contributions.


4.  Update help and guidance for LTP.



THE ISSUE 


The current tax model in Quicken Lifetime Planner (LTP) does not calculate tax on salary based upon any 401K or IRA deductible contributions.   That is, LTP applies the tax rate setting to the "Total Salaries" amount, regardless of any tax-deferred, deductible contributions.   Image 1.

For 401k and to a lessor degree IRA savers, this can result in a substantial under forecast of final plan balance. 

This behavior is seen for both 401K and IRA deductible contributions.   Only the 401K case is illustrated in this idea post. 

Adjusting the model to align with IRS withholding rules (Image 2/Reference Link),  there is a reduction of yearly income tax expense, Image 3.  And, reduction of tax expense means higher end of plan balance and a longer plan horizon.  Yes, YMMV.



                                                             THE RESULT


Assuming that the model reinvests this tax expense reduction during working years or left invested (not spent) during retirement years,  a modest change in the tax model can result in significant end of plan balance increase and extend plan horizon.  Image 4.   

While YMMV, in the example, a $3000 tax expense reduction in the model, over a 35 year career and a 4.5% real return could see an increase of end of plan balance of $ 233K (in today's dollars).   This increased plan balance could extend plan solvency, in this example,  by 4 years, more or less.

The point of this idea and exercise is to show how simplified (or mistaken) model assumptions made in an otherwise very good tool can have material effect on the model result.   In this case, more conservative that it needs to be.  



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IMAGE 1 - Shows 401k (and IRA) deductions not considered in income tax calculation





IMAGE 2  -  IRS excerpt regarding correct handling of tax-deferred contributions.  Full explanation in Helpful Links, below....






IMAGE 3 -   Shows correct handling of tax-deferred contribution in LTP






IMAGE 4 -  Shows ending plan balance impact of today's model vs. proposed model.





HELPFUL LINKS

https://www.irs.gov/retirement-plans/retirement-plan-faqs-regarding-contributions-are-retirement-plan-contributions-subject-to-withholding-for-fica-medicare-or-federal-income-tax



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Comments

  • Jim_Harman
    Jim_Harman SuperUser ✭✭✭✭✭
    edited September 27
    The LTP tax rate is a user entered value and is actually labeled "Average tax rate". One's average tax rate depends on many factors beyond IRA and 401(k) contributions, including state taxes and deductions such as mortgage interest. 

    If you have filled out the Tax Planner accurately, it estimates your current average federal tax rate, or of course you can compute it easily from a tax return.

    I think it is best for the LTP to let users adjust their average tax rate to compensate for deductions rather than have the LTP make adjustments to the tax due. 
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