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Power of 401(k) & IRAs Tax Deferred Plans

There are always questions on whether to invest your retirement savings in an IRA, Roth IRA or 401(k).  Many people realize that these vehicles are a good investment tool.  Yet, they do not know which to invest in.  It also gets confusing if your stock broker questions why you are investing in an IRA or 401(k) plan when taxes may go up in the future (to pay for things like Social Security and the national debt).  They may suggest that having your money taxed now (thus avoiding these tax deferred plans) and invested with them is a better option. This section will demonstrate why tax deferred vehicles are usually a good idea even if taxes increase modestly in the future.

You may also be questioning which tax deferred vehicle do you invest in?  The key is to understand when and how the money is taxed for each vehicle.

When Money is Taxed
401(k) Taxed when money is withdrawn
IRA Taxed when money is withdrawn
Roth IRA Money is taxed immediately when earned and investment earnings are not taxed (if used for retirement)
Non-tax deferred investments Money is taxed immediately when earned and earnings are taxable

So as you can see, a 401(k) plan and IRA have the same tax consequences.  Thus, it does not matter from a tax standpoint which vehicle you invest in. 

If taxes are constant in the future, 401(k) and IRA have the same tax consequence as the Roth IRA even though the money in a Roth IRA is taxed immediately while money in 401(k) and IRA are taxed when it is withdrawn.  Let me show why this is true.  Assume that a person age 35 invests $5,000 in each tax deferred vehicle which all earn 8.5% annually and he takes his money out at age 65.  Assume the person is also taxed a flat 30% now and in the future.

In a 401(k) and IRA
Investment is put into the vehicle tax-free at age 35: $5,000

Investment grows with interest tax-free to age 65: $5,000 x (1.085)^30 years = $57,791

Money is taxed when withdrawn at age 65 : $57,791 x (1 - .30 tax rate) = $40,454

In a Roth IRA

Money is taxed at age 35 when earned as income: $5,000 x (1 - .30 tax rate) = $3,500

Investment grows with interest tax-free: $3,500 x (1.085)^30 years = $40,454

Money is not taxable when withdrawn at age 65: $40,454

As you can see each vehicle while end up with the same amount at age 65 ($40,454) under a constant tax rate.  One may wonder how this can be when the tax for the Roth IRA was only $1,500 ($5,000 x .30 tax rate) while the 401(k) and IRA the tax is $17,337 ($57,791 x .30 tax rate).  This is because the government will take 30% of the money either at the beginning or at the end.  Now, imagine your money as a pie circle.  If the money (pie circle) expands outward at similar rates, the government will take its 30% slice whether it is on the smaller pie or larger pie.  In the end, 30% of the pie is still gone due to taxes.  Thus, in an IRA, Roth IRA or 401(k) plan, your share is the remaining 70%.

However, in a non-tax deferred vehicle, the government not only takes its 30% of the money (pie) but a portion of any investment growth

In a non-tax deferred investment

Money is taxed at the beginning: $5,000 x (1 - .30 tax rate) = $3,500

Investment is taxed along the way (assume at 15% capital gains rate annually so with 8.5% return the return will be 7.225% return due to taxes): $3,500 x (1.07225)^30 = $28,376

Money is not taxable when withdrawn because investment and earnings have already been taxed: $28,376

They key to a 401(k), IRA or Roth IRA is that they are only taxed once, while a non-tax deferred investment is taxed twice, once before it is invested and then again on earnings on the investment.  In this example, taxes would have to increase from the flat 30% to 51% (a 70% increase in taxes) before a 401(k) and IRA is not as an effective tax vehicle as a non-tax deferred investment ($57,791 x (1 - .51 tax rate) = $28,318).  Note, you can increase your tax effectiveness in a non-tax deferred investment by investing more long term (not selling or trading your investments and thus delay paying capital gains tax).  However, you are also going to get taxed at the ordinary tax rates (e.g., 30%) on short-term gains and income from other assets like bonds.  So, the 15% annual tax may not be far off (or tax rates may be higher) when blending in bonds into your asset mix. 

The key is you will always have to pay a second tax on your investment return.  So, unless taxes go up significantly in the future (or capital gain rates decrease significantly), 401(k) and IRA plans still appear to be a good tax deferred vehicle to use.  Based on $5,000 invested at 10% annual return (pre-tax) with a 30% tax bracket and a 15% capital gains (investment) tax, the difference in post-tax investment and a pre-tax investment is as follows:

 Years of Investing
Post-tax (15% tax annually)
Post-tax (15% tax deferred to retirement)
401(k) (taxed at 30%)
Tax on 401(k) to equate to post-tax investment (taxed annually)
Tax on 401(k) to equate to post-tax investment (taxed at retirement)


Things to Consider

From the examples above, Roth IRAs, IRAs and 401(k) plans are all effective, but which one is the best.  There are a few things that can make one of the plans standout.

  • Does your company match the money that you invest in a 401(k)?  If so, then I would suggest not pass up that match because it will be better than most future tax consequences (e.g., the ones listed below).
  • When will you be in your highest tax bracket?  There are 6 federal tax brackets  (10%, 15%, 25%, 28%, 33% and 35%).  It makes sense to pay taxes when your are in a lower bracket (e.g., 25%) compared to when you are in a higher bracket (e.g., 33%).  If you are at the beginning of your career (at a lower pay and tax bracket), a Roth IRA may be better because you are taxed at probably the lowest tax bracket that you will ever be at.  If you are at the peek of your career (at a higher pay level), then the 401(k) plan or IRA plan may be the best plan because if you invest in Roth IRA, you are taxed probably at the highest tax bracket that you will ever be at.  However, won't taxes increase in the future, so why not get taxed before retirement in a Roth IRA?  No one knows for sure what will happen with taxes.  If taxes increase by reducing tax exemptions, credits or deductibles or by increasing taxes on consumption (e.g., sales tax or value added tax), these tax increases would not affect 401(k) plans tax advantage.  So, taxes may increase but how much and how they will increase no one really knows.  Also, in retirement, you will also most likely be living on less money than you are now (e.g., 70% to 85% of your final salary).  So if you are in a higher tax bracket now, it may be best to do a 401(k) plan or IRA plan because you may be in a lower tax bracket in retirement.
  • Where will you move to in retirement?  If you retire in a state with no or lower income taxes than you are currently in, then it may be better to do a 401(k) plan or IRA plan to avoid current state income taxes.  This way you are taxed when you are living in a state with lower taxes.  The states with no current income taxes currently are Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming with Tennessee and New Hampshire taxing dividends and interest income only.  For a complete summary of taxes, you can look at Retirement Living Information Center.
  • Does your local municipality exempt 401(k) contributions?  Where you retire to will your local municipality tax retirement income?  Depending on the rules, the city may not which makes deferring income into a 401(k) plan or IRA plan more attractive.
  • There are other subtle differences in the plans including when and how money can be paid out.  There tends to be more flexibility with a Roth IRA. 

Sound confusing?  The key is to ask yourself where are you in regards to your future tax rates.  If you are at the start of your career than a Roth IRA may be more attractive.  If you are at the pinnacle of your career, then and IRA or 401(k) plan may look better (especially if your retirement income will be less than your making now).

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