There are rumblings in Whoville that the next round of budget negotiations will take a huge bite out of retirement plans. That politicians would even consider halting the tax-deferred status for a quick shot of tax revenue shows how incredibly short-sighted they are. Of all their socking it to the grandkids via their addiction to ever-increasing deficits and borrowing, tax-deferred retirement vehicles are the only gift they're giving those same grandkids.
Not too long ago, FiduciaryNews.com authored a members-only white paper called “Slaying the Myth of the 401k Tax Advantage Myth.” At first, you might think the double use of the word “myth” to be a typo, but it's not.
Perhaps spurred by the negative press regarding 401(k) plans, there's been a growing feeling among some seasoned professionals that the 401(k) plan has outlived its usefulness. The 401(k) plan was created when marginal tax rates were much higher than they are today.
Back then, the idea of deferring taxes when you're in a high tax rate and paying them when you're in a lower tax rate at retirement made obvious sense. Today, it's possible you'll end up in the same tax bracket during retirement that you were in while you were gainfully employed. Given this possibility, it's not illogical to question the value of the 401(k).
Yet, it's quite easy to prove the point mathematically. For the sake of argument, the white paper omits the clearly positive effects of company matching. No one would argue against getting free money. So, we took that advantage away. This left only two scenarios — investing after-tax and investing pre-tax.
We first set up a dual test (one for each scenario) comparing a monthly investment of $100 in a 15 percent category. We varied the rates of return and the time periods to make sure we caught any critical inflection points. We then ran the numbers and hit the “calculate” button to obtain the results.
What we found was rather startling.
In every single time period and for every single positive annual return, in every case the investor pays less tax in the after-tax scenario.
“Voilà!” shout the critics of the 401(k) plan, “you have proven the 401(k) Tax Advantage Myth!”
Unfortunately for those negative nabobs, their celebration is a bit premature. For, what further analysis shows, is not only does the investor end up paying more taxes in a 401(k) tax-deferred vehicle, but that same investor also will have substantially more assets after all the taxes are paid. In other words, like the lottery, both the investor and the tax collector end up with more money.
Why would today's lawmakers want to end a program that brings in more tax money?
The 401(k) tax advantage myth is itself a myth. There is and always has been a tax advantage when using 401(k) plans. Like that scene in my wife's favorite Christmas movie, the 401(k) plan is “a gift that keeps on giving.”
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Christopher Carosa
Chris Carosa has been writing a weekly article and monthly column for BenefitsPRO online and BenefitsPRO Magazine since 2011 and is a nationally recognized award-winning writer, researcher and speaker. He’s written seven books, including From Cradle to Retire: The Child IRA; Hey! What’s My Number? – How to Increase the Odds You Will Retire in Comfort; A Pizza The Action: Everything I Ever Learned About Business I Learned By Working in a Pizza Stand at the Erie County Fair; and the widely acclaimed 401(k) Fiduciary Solutions. Carosa is also Chief Contributing Editor of the authoritative trade journal FiduciaryNews.com and publisher of the Mendon-Honeoye Falls-Lima Sentinel, a weekly community newspaper he founded in 1989. Currently serving as President of the National Society of Newspaper Columnists and with more than 1,000 articles published in various publications, he appears regularly in the national media. A “parallel” entrepreneur, he actively runs a handful of businesses, including a small boutique investment adviser, providing hands-on experience for his writing. A trained astrophysicist, he also holds an MBA and has been designated a Certified Trust and Financial Advisor. Share your thoughts and story ideas with him through Facebook (https://www.facebook.com/christophercarosa/)and Twitter (https://twitter.com/ChrisCarosa).
