Fact or Fiction? Slaying the Myth of the 401k Tax Advantage Myth

Everyone knows the reason why we save for retirement: We reap the immediate benefit of deferring taxes today in exchange for paying lesser taxes tomorrow. The mantra has been repeated so often it’s almost considered heresy to challenge it. The assumption, however, that tax rates will always remain lower in the future has suffered serious damage in recent years. Indeed, Washington has recently increased the intensity of its anti-401k rhetoric, claiming the retirement plan at once both has been a failure for too many and worked too well for too few, further widening the disparity between high income and low income workers. These antagonists also allege retirement plans take away badly needed government revenues. An easy-to-understand analysis proves both of these contentions are false. Not only do the benefits accrue more favorably to lower income workers, but, when it’s all said and done, the government earns greater revenues as a result of these tax deferred vehicles.

While the partisan wordplay is generally ignored by financial professionals, it might surprise you to discover there’s no universal agreement on the tax advantages of 401k plans.

For many, the adage that opened this article remains tried and true. “The tax advantage is very real if you are going to be in a lower tax bracket in the future,” says Damian Rothermel of Rothermel Financial Services, LLC in Portland, Oregon. “The difference between saving 25% now and paying 15% in the future is significant.”

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“It is real if the average tax rate that you would have paid on any tax deferred income that you put into a 401K or IRA would have been higher than your average income tax rate in retirement,” says Mark Donnelly, Portfolio Manager at AEPG Wealth Strategies in Warren, New Jersey. “This is likely for most people as long as tax rates don’t move up too much over time. In general, people spend less in retirement than when they are earning money during their working years.” Donnelly believes it’s “very likely” today’s retirees are in a lower tax bracket compared to their working years. “On the whole,” he says, “most have done very well from tax deferral as tax rates have come down a great deal over the past 30-40 years which means that a vast majority will be paying a lower percentage tax rate than they would have done if they had not deferred.”

“Even when you are not receiving a match from your company, saving today will help ensure a better tomorrow,” says Diane Garnick, CEO of Clear Alternatives LLC in New York City. “Choosing to save $10,000 in a retirement account provides two primary tax advantages. First, saving in a 401K usually means savings begins on a pre-tax basis. This allows the entire $10,000 to work along-side you until your retirement arrives. The alternative would have required paying taxes first and then investing. Most likely that would have resulted in only $7,500 or $8,000 working on your behalf. Second, taxes in the US are based on a progressive system. Stated simply, the more you earn, the higher your tax rate will be. Most Americans will earn less in retirement than they did while working. This means the income you defer until retirement will be taxed at a lower rate.”

John Graves, from Ventura, California and author of The 7% Solution, offers this example: “If you are in the 28% federal tax bracket, then your contribution saves you $280 for every $1,000 you save for retirement. If you do not save this $1,000 you will spend $280 in taxes. If your state has a 5% concurrent tax, then your savings just increased by 5%.”

“The tax advantage of tax-deferred investing comes with the benefits of compound interest,” says Ozeme J Bonnette, Financial Coach at Tri-Quest Investment Advisors in Fresno, California. “Since there are no capital gains and interest to report (and pay for) at the end of each year, the invested funds can grow at a potentially faster rate. Current retirees should have been able to tax advantage of the tax deferred compounding in their retirement accounts. In retirement, that benefit will continue to work for them as they strategically plan the withdrawals over their retirement years.”

Readers interested in the advantages of tax-deferred saving might want to read: The Retirement Saver’s Secret (as in “Under Appreciated”) Weapon

But there are some who call this an outright lie. “There has never been a tax savings in retirement plans,” says Eric Heckman of Heckman Financial and Insurance Services, Inc. in San Jose, California. “If you put $10k into a plan, your income drops by $6,500 in a 35% bracket but you don’t get $3500 to spend elsewhere. If you don’t fund it, you get the same $6,500. If you take the funds out the next year from the 10k, you get $6,500 back. (no interest & no tax penalty) So where did the $3,500 go? The supposed tax savings went into the plan and goes to the IRS when taken back out. Say it made $1,000 in earnings. You get $7,150 back which is 10% on the $6,500 and the IRS gets 3,850, 10% on the 3500. You didn’t make more by tax deferring it nor did you profit from the taxes you didn’t pay. The only difference is the opportunity cost of the $3500 today versus waiting and where you invest those funds which may cause current taxation. So a lower tax bracket in retirement can make you profit from the plan. Very high income people can do this shift but more middle income people will retire in a higher bracket due to no tax deductions like kids & mortgages. Also you lose deduction of losses & capital gains even though you typically invest in capital gain type of assets. A lot of clients can earn $40k-60k less in retirement and have the same taxable income.”

“There is no tax advantage to a 401K contribution,” says Leonard P. Raskin of Raskin Global in Hunt Valley, Maryland. “The taxes that you save are simply in the account balance as an IOU to the Government. They make the rules regarding your cost of funds and total return and can change these at any time. Investors are told the contribution is less than it actually is because of the tax savings. This is completely false.”

Hunter von Unschuld of Fractal Profile Wealth Management in Albuquerque, New Mexico says, “The first question to ask is will taxes be lower in the future, the same as today or higher? Most people think they will be higher. If they are the same or higher than deferral is a bad idea.

Richard Bavetz, Managing Partner at Carington Financial & Insurance Services in Westlake Village, California nicely sums up the thinking of those who feel the advantages of the 401k may be overstated. He says, “If taxes are the same or higher, then there is no advantage and potentially an even higher tax liability if taxes rise.” Bavetz points out that a great number of current retirees are especially susceptible to what he calls the “reversal of fortune effect.” He says, “They contributed to their 401k when taxes were lower than they are today. They contributed to defer the taxes, based on the expectation of either being in a lower tax bracket or taxes just simply being lower overall. Since the high marginal tax rate in the late 1980’s was the lowest since the preceding 60 years it was unlikely that taxes would go down further. To make matters worse, the number of tax brackets were reduced making it harder to drop into a lower bracket at retirement.”

Everyone agrees if the tax rate is lower, then saving in a tax-deferred vehicle like a 401k is a good idea. There are many who believe it’s a wash if the tax rate is the same and a bad idea if the tax rate is higher.

There’s an easy way to test this hypothesis. We took a simple example where an employee contributes $100 per month. This employee is in a 15% income tax bracket and at 15% capital gains tax bracket. We then calculated growth over three time periods: 10 years, 20 years and 30 years. We then compared the taxes and savings for two scenarios: One where all the savings was after tax and one where all the savings was pre-tax. Here’s what we found assuming an 8% growth rate:

                After-Tax              Pre-Tax                    Delta
                                                          After-Tax vs. Pre-Tax
          Total       Ending     Total       Ending
          Taxes Paid  Value      Taxes Paid  Value       Taxes Paid   Value
 10-Years $  2,417    $  14,790  $  2,753    $  15,602   + $   337    + $    812
 20-Years $  7,688    $  44,065  $  8,865    $  50,234   + $ 1,177    + $  6,619
 30-Years $ 16,624    $ 101,988  $ 22,430    $ 127,103   + $ 5,806    + $ 25,114

This certainly dispels the myth that remaining in the same tax bracket is a wash, albeit in an ironic fashion. In all three time periods, the employee would pay more taxes using the tax-deferred vehicle, yet, the employee also ends up with more money. We changed the growth rate and found this relationship remained the same all the way down to a 0% growth rate. Only in this special case of no growth is there no difference between saving after tax and saving in a tax-deferred account. The likelihood of assets not growing over these extended time periods is virtually non-existent. The worst ten-year period still produced (slightly) positive growth. Clearly, those in the government who believe tax-deferred retirement plans “cost” the government revenues have not done this easy-to-understand analysis. Ironically, the end result of tax-deferred investing is to both pay higher taxes and to end up with more money.

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How and why is this so? “Investing in tax-deferred accounts allows the saver to benefit from the concept of ‘compounding interest,’” says Tim Munderloh, President of Munderloh Financial & Tax Advisory Group in Addison, Texas. “This means that the account will be earning interest on: 1) the principle invested; 2) interest on the interest; and, 3) interest on what otherwise would be paid to Uncle Sam each year. This is known as ‘triple compounding.’”

But what of the possibility that tax rates will be higher when the employee retires. At some point, the math shows the employee will have less savings at this higher tax rate. This is a function of time invested. For the 10-year period, the threshold is a 20% tax rate during retirement. For the 20-year period, the threshold is 26%. For the 30-year period, the threshold is 32%.

These figures may make it appear the naysayers may be right. There’s a caveat. All the numbers in the above assume the employment tax rate remains 15% for the entire period. This, however, does not represent the real world. It’s more likely the employee’s tax bracket will increase over time. To duplicate this, we changed our assumption and had the employee pay at a 32% income tax rate in years 21-30 (the capital gains tax remained 15%).  With this scenario, after 30 years, the employee will again end up with more money in the tax-deferred vehicle. In the end, most employees will have been invested in their retirement plans from between 30 to 40 years before retiring. That’s more than enough time to provide the growth needed to maintain the much vaunted tax advantage.

Does the 401k offer a tax-deferred advantage? The answer, according to the data, is an unequivocal “yes.” The irony, though, is that, in generating a net after-tax savings through their 401k plan, employees will end up paying higher taxes. It’s a little like winning the lottery. Sure, Uncle Sam gets a huge chunk of it, but, in the end, you still end up with money you wouldn’t have otherwise had.

While it should be clear to the reader that a real tax advantage exists, there’s another reason one might want to divert their primary savings vehicle to a retirement plan. “The funds in a 401k plan are protected from creditors,” says Shane Fischer, Attorney at Law for Shane E. Fischer, P.A. in Winter Park, Florida.  “If you declared bankruptcy, or were sued and had your assets seized, neither a creditor nor a bankruptcy court will be able to liquidate your retirement portfolio.”

The myth that 401k plans do not offer a tax advantage has captivated many. It, however, presents an unnecessary diversion from what really matters. Brooks Herman, Head of Data and Research at BrightScope, Inc. in San Diego, California, gives us the bottom-line when he says, “We all know that we need to save more for our 401ks. We also know tax rates can change – for higher or for lower – in the next 30 years, so trying to play a guessing game with tax rates is just silly. Plan participants need to focus on getting themselves to retirement and a 401k plan is usually a big component in that calculus.”

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