Rule of 7 Not Much Help Anymore
QUESTION: A few months ago I saw a formula called the Rule of 7 which made possible the determination of how long it takes to double your money at a given rate of interest. I have since lost that formula, and since it is very useful for the layman, would you discuss the rule?--J. T. P.
ANSWER: In the current interest-rate climate, unfortunately, the so-called Rule of 7 isn’t particularly applicable. In fact, it isn’t much of a rule at all.
What it says is that in what once was considered a “normal” interest-rate environment, a saver could expect to double his or her savings in about seven years. But since the 1970s, interest rates have been on such a roller coaster that it would be just as correct to call the savings-doubling “formula” the Rule of 5 or the Rule of 10, depending on the year.
If your money is tucked away in an account earning an annual yield of 10.41%, you will have doubled your money in about seven years. But in times of higher rates, when it is reasonable to expect a 13% return on your savings, you could double your money in just 5 1/2 years.
Conversely, if you have your money in a bank money-market account right now, you are likely to be earning something in the vicinity of 6%, in which case you can’t expect your money to double for at least 11 years. And if that money is instead squirreled away in an old passbook savings account at a bank and is earning only 5 1/2% interest, your money wouldn’t double for a good 12.6 years, assuming that it was being compounded quarterly, as most passbook accounts are these days.
Q: My neighbor says that when it came time to contribute to his IRA last April, he and his wife didn’t have $4,000 to spare, so they borrowed the money. And now he plans to deduct the interest he has paid on that loan. He says it is perfectly legal. I don’t think it is. Who is right?--G. U.
A: Your neighbor wins the tax deduction and the bet. Taxpayers who itemize their deductions are entitled to write off the interest that they pay on all debts--with the exception of loans used to buy tax-free investments. But IRAs aren’t tax-free investments. The income taxes owing on money in such accounts is simply deferred until the funds are withdrawn, for use upon retirement. So the deduction applies.
This option of funding an IRA isn’t for everyone, of course. For some, repaying the loan would be a significant hardship and hardly worth the effort. But for the taxpayer who can easily afford both the $2,000 annual contribution allowed each worker and the money to repay the loan but finds himself strapped for cash when the contribution deadline approaches, borrowing can be a wise choice--and in fact is growing in practice.
Q: I took early retirement from my longtime employer last year (I am 55) mostly because I was tired of the daily grind and the big city. I wasn’t tired of my work. So, I arranged to work for the company as a consultant and I moved to a little log cabin up in the mountains.
My question is, what do I do about the pension I got from the company when I left? I know I have the option of rolling all or part of it over into an IRA and forgetting about it for a while. What I’m trying to find out--and am getting mixed advice about--is whether I also have the option of using 10-year income averaging if I should decide to just pay the taxes now. Some advisers tell me I don’t qualify for the favorable tax-computation method and others tell me I do.--C. T.
A: What the Internal Revenue Service will question is whether you have actually separated from your employer’s service or whether you are technically still an employee. Assuming you aren’t receiving perks not available to other retirees of the company and that your work schedule isn’t dictated by the company, it appears that you could successfully argue that you meet the separation-from-service rule and do qualify for the tax-favored lump-sum distribution treatment.
If you had postponed your retirement until the day you reached age 59 1/2, you would have met a second IRS rule for determining whether 10-year averaging is allowed and you wouldn’t have faced quibbling over whether you are or aren’t separated from your employer’s service. The IRS says a distribution from a tax-qualified pension or profit-sharing plan qualifies for the favorable tax treatment (the ordinary income part of the distribution is taxed as if it were received evenly over 10 years, which reduces the tax owed) if it is paid 1) because of the employee’s separation from service; 2) after the employee reaches age 59 1/2, or 3) because of the employee’s death.
Since you are both alive and younger than 59 1/2, you must meet the separation-from-service test. In arguing your case, be sure to point out that your new home is quite distant from the location of your former employer’s offices. That would seem to indicate that the company doesn’t exercise control over how and when you work and that yours is not an employer-employee relationship.
