Last year by retiring from the University of Illinois in August, I received some rather large one-time payments. Part of that was from the Voluntary Separation Incentive Program, a program that encouraged staff to voluntarily sever from the University, which had to lower its ongoing payroll. The remainder was from accumulated vacation days and sick leave that I hadn't used up. As a result, for that one year our family income jumped up well above that magic threshold, $250K, where President Obama would like to repeal the Bush tax cuts. In fact since the cuts were extended, my new marginal tax rate became 33% (in previous years at lower income it was 28%). We sheltered as much of this as we could by putting other income into the Unversity's 403B plan. And after years of getting a pretty healthy refund, this year we owed. Taxes were withheld on the one time payments but the amount was based on the lower marginal rate. I verified with the IRS that I didn't have to pay an estimated tax. And that was that - sort of.
When I was working full time, I essentially ignored personal finance. We are middle class, reasonably comfortable, and our incomes and accumulated saving allows us to make tweaks in our spending that simply get absorbed in the flow, and who has the time to manage this at a more micro level? But having retired (which I view as a change in my contractual relationship with the university, not as an end of me working now and in the future, in fact I'm teaching now) and in the planning for that I did some arithmetic and thinking about the issues. On the earnings side, I asked myself what income I needed to generate to stay even with my prior paycheck, given that I was getting a pension payment. The psychology of why the prior earnings matter in thinking this way I will leave for others. I am now beginning to divorce myself from that calculation as I will explain below. But I will say there was some general thought of dividing my time between those things that purely would indulge my interests, writing for example, and those are things done mainly to be responsible to the family, generating income so our expectations wouldn't have to change too dramatically.
I also did some calculations on the spending side. Part of this was from moving an earlier 403B accumulation (from when I was single and socked away 20% of my salary each year) to an IRA and then thinking of the kids' college funds. My older son is a Freshman at the U of I. We developed a finance plan for his 4 years and that is pretty well in control. If he goes a 5th year, by that time I will be eligible to withdraw from the IRA. My younger son is a Junior in High School. If he goes to a public university in Illinois (preferably the U of I) that is also pretty much under control. If he goes to a private university or to a public one out of state, for that we are not so prepared. We'd probably have to borrow about 40% of the cost. So there is a potential income need. The other unknown income need is with my mom, who is 90 and has outlived her estate. She has some income but her health care costs well exceed that and the differential needs to be paid. I've contributed to that some. My brother has contributed more. Who knows how long that will last? Her care is very high quality and she lives in the same condo that she lived in when my dad was alive. She could be moved into a facility, almost surely at lower cost and probably not stick around for as long. That's too painful a decision to make, so we have the arrangement we have. It's hard to budget for that.
There is the other worry about what happens to the kids after college. How will they fare? I have several stories from colleagues about their adult children moving back home post college. That is a worry, one where if possible I'd like to self-insure. And if the worries get addressed then thoughts turn to beneficence within the family. I have friends my age who have grandchildren. My kids aren't close to being there yet, but when they do get there I'd like to help out if I can. My parents contributed quite a big chunk to the kids' college funds. That seems a good tradition to promote within the family. I do note that neither the worries nor the beneficence are about my retirement or my wife's. Are we well covered for that?
We are if the potential expenses mentioned above are not too much of a drain and if the part the health care costs that we have to bear don't escalate too dramatically. Those are some big ifs. So as much as possible I'd like to self-sure for the various contingencies. This means generating more income now and in the near future while I'm still productive. So I would like to well exceed staying even with my prior paycheck, using the residual to self-insure through saving that ultimately raises our net worth. Whether that is possible remains to be seen.
I want to make one more observation about me and then turn to the tax proposal. You can verify what I'm saying here by going to this U.S. Census Bureau page, and then downloading the H-1 table for All Races. I will use the 2009 numbers as the cutoffs for the income distribution just to make things simpler. Since my wife moved back to working where for a while she was a stay at home mom, then working half-time, upped to 80% and now full time and since I moved to the College of Business where I got a good salary bump, our household has been in the 95th percentile or higher in the income distribution. That is for about a 5 year period. The income cutoff for that is at $180,000. In the previous 5 year period we were well above the 80th percentile in income (again based on the 2009 cutoff) with income in excess of $100,000. On this I'd like to make two points. First, my thinking above I believe is typical of somebody my age, with concerns about the future because of uncertainties both in potential large expenditures and in the ability to generate income. But the station from which I aim to address these concerns has not been typical. We've been privileged income-wise, at least measured relative to the U.S. population as a whole, the advantage of a household where both parents have doctorates and good jobs at a major university. So our ability to cope and self-insure has to be much more than what is typical. Second, ten years ago when the kids were younger they were the focus then and there and this current desire to self-insure hadn't yet emerged. We lived within our means then, but didn't save prodigiously. Perhaps we should have been more disciplined about it.
There are three core issues/questions that underlie these suggestions. (1) What can be done to promote the precautionary demand to save? (2) When does self-insurance trump social insurance and when is it vice-versa? (3) What is the difference, if any, between insurance for future expense or loss of income and precautionary saving? There is a fourth question that President Obama raised in his address yesterday that I will touch on here. (4) How progressive should the tax system be? Trying to think those through I've come up with the following.
(A) Move from a system that tracks income only to a system of T-Accounts which has income on the left hand side and expenditure on the right hand side. The expenditure categories can be broad. The big thing is to make a distinction between consumption and saving. The main purpose of this is simply to raise self-awareness in the tax payer. But it is also important longitudinally for the next suggestion.
(B) Provide a tax-incentive for Precautionary Savings Accounts. These would work in a functionally similar way to IRAs regarding contributions, but would be quite different in terms of withdrawals. Eligibility for withdrawal without penalty would be precipitated by a large drop in income over the historical average or by a large increase in spending, restricting the cause of the increase to certain prescribed categories - incurring a major uninsured medical expense, having to support an adult dependent who was previously independent, perhaps some large educational expenses, etc. The balance in such accounts would roll over into IRAs after the individual has reached a certain age.
(C) Institute a social insurance scheme to provide supplemental income above social security for those people who outlive their 401K plan. In my opinion, this should be mandatory. So what needs to happen is that upon retirement a life expectancy calculation needs to be made and a fixed per year withdrawal schedule needs to be constructed that would zero out the 401K at life expectancy. That would give a baseline for the amount of supplemental income in the plan. Premiums would then be built from that and the conditional probabilities of living x years past life expectancy.
(D) Institute a social insurance for insurers of long term care. The issue is this. Presumably insurers that offer long term care policies want people like me purchasing such policies at an early age, so they have more revenue on their balance sheets. But I as a potential insured don't want to bear the risk either that the company will go belly up in the future before I receive any long term care coverage or that they will jack up their premiums when I'm older and essentially locked into them as a provider. So even if long term care is essentially an outside of medicare transaction, there needs to be some government guarantees behind this insurance.
(E) Recognize the role luck plays in income determination. With that either (a) base marginal tax rates on a weighted average of net worth and current income or (b) take a simple average of the last 5 years income and base tax rates on that. For this, capital income cannot be exempt. In becoming rich a person takes current labor income and converts much of it into future capital income. If we are income averaging over time, we need to account for the whole not just the part. There is a big deal, in my opinion, whether on this point only realized capital gains should be taken as income or if accrued capital gains should be considered as well. This is why net worth may be the better bet, in spite of the issues in measuring the value of real property that hasn't been recently traded. There should be no issue at all in measuring financial assets which do have a market in determining accrued gains.
(F) Raise marginal tax rates gradually for all households starting at the 80th percentile, $100,000 a year, in such a manner that reaching the 98th percentile you have the Obama proposal to eliminate the Bush cuts. That is the burden of tax increases should be much more broad than is being proposed at present. The message needs to be shared burden, not punitive on the rich.
(G) Develop a profile on household net worth that parallels the profile on household income. It is is rather odd to talk about fiscal policy by focusing on Federal Debt and GDP without also including private debt and how that is distributed across households. Both should be brought into focus.
I don't have a clue of who would support such a set of recommendations. It's quite easy to envision that any hint of raising taxes on your own constituency, for example, is a political loser. My only hope is that one might reason this through for the life-cycle as I tried to do in discussing my own situation. I'm bothered by the Republican line "we're taxed enough already." I'm also bothered by using the baseline of the historical share of Federal spending to GDP. The world is changing. People are living longer and much of their health care costs are skewed to when they are older. Government needs to be involved in this in some way. What is the right way for this future world? That is what I'm trying to ask here and what my suggestions are meant to address.