Ordinarily investing vs iDeco investing

[adamtokyo]

Hi everyone,

I got a bit of shock when running some numbers over two different investing scenarios; investing via an ideco vs ordinarily investing. I'm seeing ordinarily investing yielding 30% more before tax. I'm wondering either my calculation methods are off or tax on investment gains must be huge.

Both scenarios assume:

• You invest a whole 2 yen per month (to keep the figures small)

• You start when you are 10 (very good parents).

• You stop when you are 70.

• You are eligible to invest via iDECO between ages 20 and 60.

• Annual rate of return 5%.

• Stating off with 0¥.

If ordinarily invested then the final amount over 60 years would turn into ¥9139 before tax.

If invested via an Ideco it would be ¥6205 before taxes are paid for the first and last ten years which were ordinarily invested.

That's 30% less than ordinarily investing. Is this to be expected?

Here's how I calculated the Ideco scenario:

• Years 10-19 the money is ordinarily invested as not eligible to use an Ideco. ¥2 per month for 10 years yields ¥311.

• Years 20-59 the money is invested via Ideco. ¥2pm for 40 years yields ¥3064. Meanwhile the ordinary investment has grown to 513¥

• Year 60 the ideco is cashed out at ¥3064 and lumped together with the 513¥. Total pot is now ¥3578 and ordinarily invested again making 2¥ monthly contributions.

• Year 70 The total pot is ¥6205

Is my methodology sound here?

[RetireJapan]

Well, if you invest 2 yen a month and pay the iDeCo fees you're going to get scalped. How about a more realistic 10,000 or 20,000 yen a month?

[adamtokyo]

Hi Ben,

Yes I kept the monthly investment unrealistically small just to keep the subtotals small for readability purposes. I was willing to ignore fees.

Anyway, I went back and reviewed my calculations and I actually made an error here:

Years 20-59 the money is invested via Ideco. ¥2pm for 40 years yields ¥3064. Meanwhile the ordinary investment has grown to 513¥

The ordinary investment actually grows to 2288¥.

This means following the methodology outlined in my first post, the iDeco route now equals ¥9139 which is almost identical to the ordinarily invested scenario.

So my original concern that splitting one big ongoing investment into two smaller ongoing investments would yield less is no longer an issue.

I am still wondering if my calculation methodology is correct. Do you see any logical flaws in it?

[RetireJapan]

Well, if you invest in index funds, reinvesting the dividends there shouldn't be any taxable events. You would expect similar performance to the tax-free iDeCo.

What complicates things is the income tax break and the eventual tax on iDeCo. For most middle- to high- earners, this will be a huge boost.

[adamtokyo]

Thanks Ben,

Just to avoid any ambiguity ...

> Well, if you invest in index funds, reinvesting the dividends there shouldn't be any taxable events. You would expect similar performance to the tax-free Ideco.

You mean when you invest into an index fund via an Ideco, if you make sure to automatically reinvest any dividends earned then they will not be subject to income tax?

> What complicates things is the income tax break and the eventual tax on Ideco.

I'm a little confused by this - can you explain what you mean by this especially "the eventual tax on Ideco.". I thought profits made in an Ideco are 100% tax free.

[RetireJapan]

Sorry, that wasn't very clear was it?

You mean when you invest into an index fund via an Ideco, if you make sure to automatically reinvest any dividends earned then they will not be subject to income tax?

You can currently only invest in mutual funds in iDeCo, and the dividends are reinvested automatically.

I'm a little confused by this - can you explain what you mean by this especially "the eventual tax on Ideco.". I thought profits made in an Ideco are 100% tax free.

iDeCo has a tax-free allowance (calculated at 400k yen per yer of contributions for the first 20 years, then 700k per year after that to a max of 15m). Half of anything over that will be taxed as income. This is in the case of taking a lump sum.

You can also take your iDeCo as a pension, which is taxed as pension.

You can probably ameliorate this by timing your iDeCo withdrawal for a year when you won't have income (as you can take it any time up to age 70).

[adamtokyo]

Ah thanks for the explanation. The iDeco isn't as simple as I assumed it to be especially compared to the UK ISA where your investments whole amount is tax free.

> DeCo has a tax-free allowance (calculated at 400k yen per yer of contributions for the first 20 years, then 700k per year after that to a max of 15m). Half of anything over that will be taxed as income. This is in the case of taking a lump sum.

Ah so if a person invests in the iDeco for 40 years then the tax free part of their final investment would be calculated as follows:

400,000 * 20 = 8,000,000
700,000 * 20 = 14,000,000
Tax free allowance = 22,000,000 but crosses the threshold of 15m
Therefore tax free allowance is 15m + Half of anything over that. The other half will be taxed as income.

If the persons investments grew to 15 million then the whole 15 million would be tax free on cashing out.

If the persons investments grew to 20 million then 17.5 million would be tax free (15 million tax free and half of the remaining 5 million is also tax free with remaining 2.5 million being taxed as income dependent on the individual's circumstances - drawing as pension, employed/unemployed etc)

Is that about right?

[RetireJapan]

I believe the tax treatment for lump sum and pension style withdrawals are different. Will look into this and do a blog post soon.

[jcc]

re: tax treatment of iDeco

Don't forget that you're not paying income tax on the funds you put in!

E.g. if your nominal income tax is say 25%, you're basically getting an extra(untaxed) 5000 yen for every 15000 you put into your ideco.

So, going back to your original example, you'd be investing 2 yen into ideco or 1.5 yen into your normal account(the other .5 would have been taken out of taxes)

You asked about "multiple smaller investments" versus one "big one". So long as there are no fees attached, there is absolutely no difference.

Say for example you have 10 accounts with 1000 each or 1 with 10000, and 5% returns. After 5 years you'd have 10 accounts of 12762.8 or one of 127628. It's the exact same.

iDeco due to its huge tax advantages(both when putting money in, and when taking it out) is a huge win, and the only possible reason to not use it would be dissatisfaction with the choice of funds you can invest your money in

[adamtokyo]

Thanks Ben and Jcc,

Wow didn't realise the iDeco was that good. Unfortunately this now complicates things on my side. The reason why I've been asking these questions is because I've been building a calculator as a little fun project for my personal portfolio (I'm a web developer by day). You enter some basic investing criteria and it shows you your investment after x years. E.g. start investing ¥10,000 at 5% when 20 years old for 40 years would yield you ¥xxx,xxx,xxx.

I've also tried to illustrate how much of your final investment can be protected from tax by investing via an Ideco. However, after everyone's helpful answers it seems my assumptions were incorrect. Perhaps this is a road I should avoid going down.

Perhaps illustrating the tax relief when putting money in would be useful though so thanks for the info Jcc.

A very rough prototype is here (complete with typos and errors ) http://buildanestegg.s3-website-ap-nort ... zonaws.com

Would love any feedback or suggestions.