What does "Chained CPI" Mean?

A popular way to reduce expenses and raise revenue in DC is to pass legislation that isn't felt today, but felt in the future.  It's a convenient way for policy makers to have a meaningful impact on the trajectory of the Federal debt (not the deficit) without having their constituents understand what they have done until it is too late.  One idea that has been around for a long time is changing the way that we measure our Cost of Living Index (COLI) to "chained" price increases and attempting to measure a substitution effect as a result of price changes.  Huh is a perfectly reasonable response.  

There is a very simple way to think about this.  Let's assume that you go to the grocery store one day and the price of four boneless skinless chicken breasts is $10 and the price of four pork chops is $10.  Four weeks later you go back to the same grocery store and the price of the chicken breasts has doubled to $20 but the price of the pork chops has remained the same.  Are you still going to buy the chicken breasts or are you going to double up on the pork chops?  Economists argue that most consumers will double up on the pork chops.  But that isn't the way that the current consumer price index calculates it.  It assumes that you have a fixed basket of goods and you don't change your spending habits no matter what happens.  

The Chained CPI tries to take a different angle.  The Chained CPI takes into account the historical price of a item relative to its current price and substitute items and assumes that consumers will make changes based on the current prices relationship to its historical price and other similar items.  Huh?  It assumes you buy the pork chops rather than the chicken.  In essence, it allows you to change your basket of goods based on prices in the market place.  

In other words, the historical index doesn't allow you to change your spending habits based on higher or lower prices but the Chained CPI does.  

Believe it or not, the Chained CPI (technically referred to as the C-CPI-U) has only been around since 2002 but because it has a two year lag it has been measuring prices since 2000.  Over that time period, the Chained CPI has averaged about 0.2% less than the traditional CPI which doesn't seem like much until we think of the impacts that it could have on the two places it is being talked about: Social Security benefits and tax brackets.

Details:

Social Security benefits 

If you start taking your Social Security benefits at age 65, receive $18,000/year (or $1,500/month) in the first year and live to age 90 a pretty large disparity will show up with "just" a 0.2% reduction in the annual increase.  

Assume two cases.  In one case you will receive a 3% increase every single year and in the other case you will receive a 2.8% increase every year.  At the end of the first year, the difference between a 3% increase and a 2.8% increase is just $36/year.  However, after 25 years that annual difference is now almost $1,800 (10% of your initial annual benefiti) and at the end of 30 years the difference is almost $2,500 per year.  That doesn’t sound that large, but the difference is between receiving $37,688/year and $35,900/year.  For Bill Gates, that isn’t a big difference but for someone who is just receiving Social Security benefits – with no other assets or income to support them - it is a large difference. 

Most politicians understand the impact that this has on those seniors who live an extended life (mostly recognized as living either to age 80 or 85).  Therefore, most proposals that adjust the way we increase Social Security benefits incorporate a one-time large increase in the benefit at 80 or 85 to get the recipient back to or near where they would have been under the current formula. 

Tax brackets 

The other case is in tax bracket adjustments.  If tax brackets are allowed to increase annually for inflation and the way inflation is calculated is held to a lower rate of increase then your future taxes will increase as well.  

If we apply the same 3% increase and 2.8% increase to the top end of the current 15% tax bracket then we come out with a similar result.  For reference point, the top of the 15% tax bracket is represented by taxable income of $72,500.  After one year, the difference is $145 – meaning that the last $145 is taxed at the 25% rate rather than the 15% rate.  This results in an anticipated higher tax bill of just $14.50.  However, at the end of 25 years the difference is $7,200 with a higher tax bill of approximately $720 and at the end of 10 years the difference is approximately $10,000 for a higher tax bill of about $1,000 annually. 

It may sound like a small tax increase and it is.  However, if you start doing the math at higher income levels you are having a much larger increase in the overall tax liability.  Therefore it should be welcomed by those who favor a more progressive tax code as it does have a small impact on lower and middle class families while having a larger impact on those taxpayers earning higher income. 

Applying the Social Security adjustment against millions of future recipients will significantly reduce future government expenses.  In addition, changing the way that the government collects revenue through tax bracket adjustments will raise an enormous amount of new revenue to the table. 

ATRA – Roth Conversion and the 401(k)

Congress passed an important tax relief package earlier this month called the American Taxpayer Relief Act (forever known now as ATRA) – in case you hadn’t heard – and one of the more interesting provisions is the ability to do a Roth conversion within a 401(k) plan. 

What

Before January 2^nd, employees were mostly prevented from moving assets from the traditional, pre-tax portion of their 401(k) to a Roth component of the same 401(k) plan.  Yes, it was available to those employees who otherwise were eligible to take a distribution from the plan but that was rather limited. With the passage of ATRA, though, Congress has now opened up the opportunity for anyone to move assets from the traditional, pre-tax portion of the 401(k) plan to the tax-free , Roth portion of their 401(k).  In the financial community, the process of moving assets from a traditional account to a Roth account is called converting (aka, a Roth conversion).  

To be clear, it is not as simple as simply moving assets from the traditional 401(k) account to the Roth account.  In order to do this, you have to pay taxes – at your current income tax rate – on however much you convert.  But the end result is that the assets will now grow tax-free and will be distributed income tax-free (under most circumstances). 

Impact

The impact on this is probably fairly limited to most people – or at least it should be.  However, the obvious segment of the population that this benefits are those young people – likely still in their 20s or early 30s – who are still on an upward trajectory in their career paths , have some savings in the traditional 401(k) plan and also aren’t already in a high tax bracket that they anticipate will fall in retirement.   

In other words, it makes sense for people who expect to be in a higher tax bracket in the future when they start taking distributions from the account. 

Planning

So ATRA opened up the possibility for people to move assets from the traditional 401(k) to the Roth 401(k), should you do it?  It depends really on two factors one of which is a complete unknown for most:

      

      1)      Do you expect to be in a higher tax bracket in retirement than you are now?  If the answer is yes, then you should convert assets now as long as you can answer yes to the next question.

      2)      Do you have the cash to pay the taxes today – or technically next year on April 15^th?  You see in order to convert the assets from the traditional account to the Roth account you have to pay income taxes on it today. 

For parents of young adults who see the value in the Roth account and have the cash available to help their children, this may be a very good opportunity. Talk to your adult children about the opportunity, get an understanding of their current tax picture, and know how much they may have in their 401(k).  If they have a lot – or more than you are willing to gift them to pay the taxes – then consider advising them to do a partial conversion.  In other words, if they have $25,000 in the traditional IRA and you only wanted to give them $2,000 to pay the taxes then figure out how much $2,000 will convert – or ask your financial professional to assist you. 

How do I Cancel my EIN?

Most people lay in bed at night wondering about world peace, how their children will adapt to a global economy, where their next meal will come from, or any other number of important items.  I oftentimes think about the little things like what happens when you no longer need your Employer Identification Number (EIN).  

An EIN functions for businesses like the Social Security Number functions for individuals and there are a host of reasons that businesses need to obtain an EIN.  The number one reason that we typically see clients obtain an EIN is to allow them to set up an individual 401(k) for the consulting businesses as they transition into retirement.   So oftentimes we see clients establish an EIN with the IRS, open up an individual 401k and fund it for a few years while they transition from their career into full retirement.  But what happens to that pesky little EIN?  Does it 'die' with the business?  If so, how does the IRS know that it has 'died'? 

The simple answer according to the IRS is that the EIN is unique to each business and is never re-assigned.  You can send a letter to the IRS indicating that the business is no longer in need of an EIN (click here for the instructions) but they do not re-assign it.  They suspend it but the EIN is still tied to your business just in case you need it again in the future. You can click on the following link which will take you to the IRS website with the specific steps:

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Canceling-an-EIN---Closing-Your-Account

Fortunately, if you were laying in bed wondering about what happens to the EIN of businesses who no longer need them, you can now move on to thinking about more important things.

Where is Inflation? 

The classic economic short-hand definition for inflation is when you have "too much money chasing after too few goods."  In other words, the more money that you pump into an economy AND the faster that money is spent the more likely you are to have inflation.  Many wise consumers are worried about the impact of the Federal Reserve "printing" too much money through its various quantitative easing measures since the Great Recession.  After all, the Federal Reserve has expanded its balance sheet by trillions of dollars in an effort to stimulate the economy. 

Consumers are naturally worried about the impact of inflation because the classic definition indicating inflation includes the phrase “too much money.”  It is true that too much money is one of two causes of inflation.  However, that money actually has to be spent in the economy in order to create inflation.  As an economics major, I spent many days living on a two person island during class.  So let me take you to a two person island for a quick example. 

You live on a two person island with me.  You and I both have $1.  I have lots of sunglasses and you have lots of sunscreen.  I decide that your sunscreen is worth $1 dollar so I give you a dollar and you give me X units of sunscreen.  You think it is a fair deal because you want to have two dollars rather than the $1 that you had.  Later that week, you decide that you want some of my sunglasses and you give me $1 for X units of sunglasses.  I am happy because I like having my dollar back.  We go back and forth like that for a while and we feel that price is at equilibrium.  

Now one day you and I discover $18 has floated up on shore.  You find $9 and I find $9.  The impact of the new money can be quite obvious.  You could tell me that X units of sunscreen is now going to cost me $10 rather than $1 dollar.  Boom - inflation just increased my costs from $1 to $10.  There was more money in the system and now inflation occurred.  

However, what happens if I decide that your X units of sunscreen are not worth $10.  I want to keep my $9 and since $1 dollar will not buy X units I decide that I don't want any units.  Instead of using your sunscreen, I decide to sit in the shade during the day and learn to fish at night.  I am essentially saving my money and not spending it (sound familiar to today’s economic woes).  Sooner or later, you decide that because the consumer (me) is not spending money the price should be more reflective of the demand.  Therefore, you lower the price of X units back to $1 dollar.  At that point, I become interested and buy your sunscreen again.  

That is the result of too much money in the system that isn't being spent and therefore is not creating inflation.  Does that sound familiar?  Haven't we seen household debt decline over the course of the last 5 years?  In essence, paying down debt is a function of savings.  In other words, the Federal Reserve is pumping a lot of money into the system but it isn't being spent in the economy by the consumer.

Now the risk of inflation is clearly there because there is a bunch of new money in the economy.  However, until consumers start spending it on their islands we are unlikely to see inflation being a BIG impact in the economy.  

Let me state the obvious.  We don't live on an island with just two consumers.  We live in a dynamic global economy.  Our prices are impacted by a number of inputs and the emerging consumers of China, India, Brazil and many other economies.  In addition, the above example is a gross simplification.  While it is useful to oversimplify in cases, it also highlights many false cross assumptions.  However, the basic outcome is the same.  There is a lot more money in the economy right now but consumers just aren’t spending it fast enough to create inflation.