Thursday, August 27, 2009

Your Retirement: The Double-edged Sword of Inflation

No one among us dislike lower prices for basic goods. If gas is inexpensive, our sentiment on the economy improves in tandem. If food prices fall, our personal budgets rejoice with the addition of some financial breathing room. Inflation has this effect like no other measure available in the economy.

And although the measure is of a basket of items (goods and services, ironically with food and fuel removed because of their volatile nature), it is a lagging indicator and open to refinements and adjustments. Yet it is still the number we associate with spending. How far each dollar will go is especially important in tougher economic times (and they don't get much tougher).

The inflation rate over the last nine years picked a year ago last month at 5.60% due in large part to the cost of oil - not the commodity itself but the effect it was having on the "goods" in the basket of measurable items. But since then, as oil prices fell, so has inflation. Last month it had turned negative at 2.10% (Here are the rates since January 2009 by month: 0.03%, 0.24%, -0.38%, -0.74%, -1.28%, -1.43%, -2.10%).

The bad news for seniors (and any other contract pay raise linked to COLA or cost of living adjustments), their benefits (or wages) will not increase in any noticeable fashion. Some seniors, if they pay for Medicare with a deduction from their Social Security, due to the increase in premiums, this lack of inflation will be easily mistaken for a cut in benefits.

Now, for some reason, which we will speculate on a little further on, the IRS is attempting to index your 401(k) deduction to this rate. If they are allowed to do this, and Congress can intervene before it takes place in 2010 tax year, your maximum contribution you are eligible to make will fall $500 to $16,000.

For most, this is a mote point. Far too many people are unable to make the maximum contribution in a time when employers have slowed, if not ceased matching employee contributions. But for those who can, this is a backdoor tax that could be the first step in drawing additional revenue for the government, at a time when it is needed most.

Exactly how much potential revenue is not known. There is still some legal wrangling to even see whether this can be done - it never has before - but I would be willing to wager that Congress will not act.

Folks who max out their 401(k) on salaries of $60,000 or less will need to have the rules rewritten in their workplace to allow for a contribution of that size to be made. Contributing 33% of you pre-tax income to your 401(k) would leave with a small paycheck (if you contributed just 5%, you would take home about $220 more than someone who made a maxed out contribution - which also includes some room for the employer to make their match) but a huge retirement nest egg, particularly if you have an early start of the process.

This will, without a doubt, have the biggest effect on high wage earners. Even with 14 million workers idle due to layoffs or other economic situations, the US work force totals 154,504,000. If the IRS is permitted to enact this change in deductions and assuming that the top 10% of the wage earners, the folks most likely to make that sort of sacrifice and you use the lowest tax bracket in the group, the government would, in theory, net an additional $2 billion in revenue.

So for the vast majority of wage earners, setting aside and investing any available pre-tax cash into your 401(k) plan is worth doing. Even if your employer has suspended their match or significantly altered it from the year prior, continue to use this type of plan.

And while I have you, I need to re-emphasize the difference between savings and investing. When you put money away in a retirement account, be it a self directed contribution or an automatic withdrawal via payroll into a 401(k) plan, you are NOT saving money. You are investing. My belief is that this may have been part of the problem with these plans; folks thought that they were saving when in fact they were investing.

Investing comes with certain obligations such as knowledge of risk and your tolerance to it as well as a keen sense on how to use that information over a long period of time.

If I could get everyone to call this what it is, I think we could approach this whole retirement situation with a more clear goal and calculated approach.

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