The Financial Feasibility of Tax-Sheltered Individual Retirement Plans: A Reply

Abstract

In her comment, Dr. Theresa Vaughan claims, in the first paragraph, that my results conflict with those of Adelman and Dorfman. Their article titled A Comparison of TDA and non-TDA Investment Returns appeared in the March 1982 issue of this journal. She contends that these two authors also examined tax-deferred annuities where the tax rate during the withdrawal years exceeded the tax rate during contribution years and concluded that even in the worst case the TDA (TSA) performs well in time. Adelman and Dorfman state, . . . the unfavorable results only occur if one were to jump from a relatively low to a relatively high tax bracket in a short period of time just before withdrawing a However, they never specified how much unfavorable, how big a jump, how much relatively low-high tax discrepancy, or how short that period is. In the absence of such specifications, their broad statement above sounds very much like my conclusion that TSA (TDA) is unfavorable when the investor's marginal tax rate after retirement (t') is higher than before retirement (t), on the basis of specific premises and assumptions (pp. 87-9). Each of these two models is based on certain assumptions and utilizes a different approach. Adelman and Dorfman were concerned with the internal rate of return measurements of tax-deferred annuities (TDA). This approach requires an estimation of the fund accumulation of benefits at retirement. In doing so the mortality factor of living to retirement (making contribution) and after retirement (receiving benefits) was ignored. Treating uncertain future cash flows as certain produces a favorable bias for TDA. On the other hand, the cash flow model in my article applies the investor's approach of investing in TSA only if the net cash flows (present value) after tax at the investor's opportunity net rate of return (discount rate), mortality,