Is It Worth Contributing To Tax Deferred Retirement Accounts?

June 20, 2018

  • Tax-deferred retirement accounts such as 401(k)s, 403(b)s and IRAs are so valuable that they are a mandatory strategy for every individual’s retirement plan.
  • Compared to non-deferred investments, tax-deferral makes sense as it will lead to a larger nest-egg for your future.
  • The only circumstance in which deferral will not makes sense is if you end up at a higher tax bracket after retirement. While possible, deferred investments will still pay off making them worth the risk of higher taxes.
Tax deferred investments are any accounts that allow you to invest pre-tax funds and delay paying the tax until withdrawals are made. These are accounts that most people have heard of such as 401(k)s, 403(b)s, or IRAs. Most are offered through your employer and offer a wide range of investment options.

The benefit of tax deferral

The benefit of tax deferral is straight forward. If you earn $50,000 in income, let’s say you decide to place $10,000 into a tax deferred account. When you file your taxes, your tax return will say you only made $40,000. Assuming you are at a 25% combined federal and state tax bracket, you just saved $2,500 in taxes.

Another way to look at the benefit is in the amount you can invest for the future. If you earn $50,000 and you are at a 25% tax bracket, if you chose to invest in a taxable strategy, you would have to claim the $10,000 as taxable income, pay the $2,500 to the IRS and you would only have $7,500 left over to invest. So, if you choose the tax-deferred account, it’s like you are getting $2,500 of government money for free, and the government is allowing you to get growth in the funds until it’s time for withdrawal.

What’s the catch?

Of course, there’s always a catch. First, once the money is in the tax deferred account, you have created a contract with the government, and submitted those funds to a set of rules under which you can not touch the money. You can’t think of it as your money any more. It’s partly your money, but some of it is also the government’s money, and they are going to want a piece of it someday. The rules are simple. You can’t touch the money until after age 59 ½. If you do, you will be hit with a tax penalty of 10% over and above normal income taxes, which represents a big hit to your long-term goals.

Second, the funds are fully taxable as income upon withdrawal. No, you didn’t really save on any taxes, you just delayed the tax liability to an unknown future. Look at the chart above. Assuming you are going to pay the same 25% tax upon withdrawal of the funds, there is actually very little difference compared to a non-tax deductible deferred account.

The chart shows that a $10,000 annual investment for 20-years getting 6% would grow to $389,927. If you paid the 25% tax up front and invested only $7,500 per year for 20-years, you account value would be $292,445. Upon withdrawal from the deferred account, assume you would need to pay 25% tax on the $389,927 withdrawal, you would be left with $292,445. They are the same.

So, is there a benefit to deferral?

The analysis above seems to indicate that deferral has little benefit since you end up paying the tax at some point anyway. But there are many circumstances under which deferral makes sense.

Your tax rate changes in the future

The most common reason sited as a benefit to deferral is based on the premise that, upon withdrawal of funds from your deferred investment, you will be subject to lower taxes. The thinking is, after retirement, you are at a lower income level, so you will fall into a lower tax bracket. So, is it possible? After retirement, there is a good chance you will have less financial responsibilities. In theory, your kids should be on their own, education expenses are gone (although don’t forget about your grandkids), and your mortgage should be paid off or close to it. Therefore, you won’t need to make as much, so your lower income will put you into a lower tax bracket.

Just remember, though, you are making a big bet on the future of the country. It is a dangerous thing to assume taxes will remain relatively stable over the next many decades. The United States has massive debt, increases in government deficits annually, an ever increasing trade deficit, low economic growth, and government entitlements and pensions that are underfunded to a level that we have no idea how we are going to live up to the promises that our politician have made.

The alternative investment is taxed upon withdrawal

In comparing the example above where both the deferred and after-tax investments yielded $292,445, an important calculation was left out. The assumption was made that the after-tax investment is tax free upon withdrawal. The reality is, upon sale of the asset, say the investment was made in a stock, there will be capital gains taxes owed. $7,500 per year invested for 20-years is $150,000. Sell the asset for $292,445 and you will own capital gains tax on the gain portion, $142,445. After paying a 15% capital gain tax, that drops your investment value to $271,079, giving a clear advantage to the deferred investment.

The alternative investment is taxed annually

Capital gains tax dropped to sale price of the alternative investment, but what if the alternative charged tax annually on the interest generated within the account, like a bond mutual fund? The final chart above illustrates the effect. The account value would only grow to $245,874.

Conclusions?

From a mathematical perspective, tax deferred investments such as 401(k)s and IRAs don’t have much advantage over alternative investments. But, upon further analysis, there are many examples of situations where they do provide a real advantage, making deferred investments a powerful tool in planning for retirement. So is it worth it to contributes. From a tax perspective, yes, deferred investments should be a part of every investor’s retirement plan. If you get matching funds from your employer, then it’s an even stronger yes.