Contributions to a 401(k) account provide immediate tax benefits because they are generally done on a “pre-tax” basis.  Each dollar contributed reduces your taxable income one dollar in the current year.  Income earned on the investments is also sheltered from tax each year.  For example, the interest and dividends earned on the investments in the account are not taxed when paid, but instead are deferred until you withdraw funds in retirement.  All money withdrawn from the account is included as taxable income at the time of distribution.  (“After-tax” or Roth contributions are treated differently; see comments below.)

Most people find that their tax rates drop once they’ve retired.  This favors the traditional pre-tax 401(k) contributions.  For example, you may be in the 25% tax bracket in your working years, but only the 15% tax bracket when retired.  By making pre-tax contributions, you are keeping some of your income today from being taxed at 25% with the expectation that it will be taxed at 15% later on.

However, future tax rates are uncertain.  The likely outcome is that income tax rates are going higher.  Does this make pre-tax 401(k) contributions a bad idea?

It depends on your alternatives.  You might consider Roth contributions if they are available to you.  You do not receive a tax benefit up front, but qualified withdrawals of contributions and earnings aren’t taxed later on.  So if your tax rates go up between the time of contributions and distributions, the Roth is likely to be favorable over the pre-tax contributions.  (Note: Roth contributions are made on an after-tax basis.  There is a separate type of “after-tax” contribution that can be made to some plans where there is no upfront tax benefit, taxes on earnings are deferred until withdrawal, and initial contributions are not taxable upon withdrawal.  Make sure you find out which type is involved if your plan allows after-tax contributions.)

So if you are concerned about rising tax rates, the Roth option may be worthwhile compared to pre-tax contributions.  But we sometimes see recommendations that people should skip retirement accounts all together and invest only in personal investment accounts.  This way, you will be able to take advantage of the lower taxation of capital gains and dividends vs. the eventual higher ordinary income tax rates on DC plan withdrawals.  There are two very good reasons that you may not want to take this advice.  1) Under current tax law, your ending wealth will usually be lower by not contributing to retirement accounts. 2) If tax rates do move up as predicted, it may actually make retirement accounts an even better choice.

By keeping money in a taxable account instead of a tax-deferred retirement account, you will have to pay taxes on interest, dividends, capital gains, etc. each year that could have been deferred to a much later date.  The higher the tax rates along the way, the greater the benefit you receive by deferring taxes over many years.  If tax rates rise just when you’re about to start withdrawing funds, you may not benefit as much as originally anticipated.

Let’s consider some examples in detail.  (Note: All assumptions for investment returns and tax rates are hypothetical and are not guaranteed).  Johnny and Sarah have identical tax rates and identical investment portfolios; the only difference is that Johnny is worried about rising tax rates and invests in a taxable account, while Sarah invests in a tax-deferred account.

Johnny has a balanced stock & bond portfolio in a taxable account with a 4% total income yield today on his portfolio (2% from dividends and 2% from interest).  Assuming Johnny pays 25% in taxes on interest income and 15% on dividends, 0.8% of the portfolio will go towards tax payments each year.  That can have a significant impact over the long run, due to the impact of compounding.  We’ll assume his portfolio also receives 3% price appreciation on his portfolio each year, none of which is taxable until he sells his portfolio at the end of his investing time frame, at which point he pays taxes at favorable capital gains rates of 15%.

Sarah invests in a tax-deferred account and receives the same 4% income yield and 3% price appreciation, but she does not pay taxes until she withdraws her money at the end of her investing time frame, at which point she pays taxes at her ordinary income tax rate of 25%.  Assuming that she invests $10,000 into her tax-deferred account, Sarah will receive a tax deduction of 25%, or $2,500, in the current year.  Thus, the net contribution is $7,500.  We’ll assume that Johnny invests $7,500 into his taxable account.

Who will be better off over time?  You might be tempted to say Johnny, since much of his income will be taxed at 15%, while all of Sarah’s income will be taxed at 25%.  But this ignores the substantial benefit that Sarah receives by deferring all of that income until it’s withdrawn.

The chart below shows that Sarah’s Pre-tax Retirement Plan (burgundy), net of tax, grows to a greater amount than Johnny’s Personal After-tax Investment Account (green), regardless of whether the time frame was 10, 20, or 30 years.  In this case, where Sarah’s initial tax deduction rate (25%) is the same as her tax rate at the end point, her tax-deferred account is the clear winner.
 

But what if tax rates rise in the future?  Leaving all other assumptions equal, let’s change the tax rate that Sarah will pay upon withdrawing her funds from 25% to 35%.  Now we see that Sarah actually falls behind Johnny if the time frame is 10 years; her tax deferral benefits have been outweighed by the higher tax on distributions.  Yet, she still has the advantage over 20 and 30 years.

In that case, Sarah was hurt by the fact that she had a higher tax rate when taking money out than when she put money in.  But what if tax rates are already higher at the time of the contribution?  This 3rd case, we’ll assume a 15% hike in tax rates across the board relative to the first case: the ordinary income tax rate in pre- and post-retirement is 40%, while the qualified capital gain & dividend tax rate is 30%.  The result is that Sarah’s advantage over each time period widens, particularly over longer periods.  The higher the tax rates, the higher the benefits of tax deferral.

(If you would like to try out more scenarios with varying tax rates and investment returns, download this free spreadsheet and test for yourself.)

So what can we conclude?  The impact of changing tax rates is very relevant and can impact what type of account you should invest in.  It is possible that an investor with a short time horizon could be better off not using a tax-deferred account.  But generally speaking, this is not the case.  This is where an analytical evaluation of the situation, as opposed to an emotional response to potentially higher taxes, can help investors identify what really is in their best interest.

Modus Advisors helps its clients with questions like this every day.  If you’re not sure whether you’re taking the right steps on your financial path, please call us at 952-946-1000 to set up an initial consultation.

*Generally, qualified withdrawals from a 401(k) are those occurring after age 59.5.  Some exceptions apply.  See your tax professional for further information.