Many Americans don't understand how tax incentives for 401(k) s and similar retirement plans work, so it is up to financial advisors to educate participants about the best ways they can take advantage of them.
According to Mike McNamee, chief public communications officer at the Investment Company Institute, one of the traps that people fall into is believing that benefits are driven by a saver's tax bracket.
The biggest reason for the misunderstanding is that a tax deferral into a defined contribution plan is often lumped together with tax deductions like mortgage interest expense from income and tax exclusions like employer-provided health insurance premiums from income.
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"But a deferral of tax is neither a deduction nor an exclusion," he said. "Tax deferrals reduce taxes paid in the year of deferral but increase taxes paid in the year that the income is recognized. Deductions and exclusions, on the other hand, reduce taxes paid in the year they are taken—period."
In addition, the age of an individual is more important than their marginal tax rates in determining how much they benefit from the deferred taxation of compensation contributed to employer-provided retirement plans.
The ICI's report, "The Tax Benefits and Revenue Costs of Tax Deferral," found that in realistic simulations for a variety of investments, the tax benefit from a one-time $1 contribution to a retirement account is greater for a 45-year-old with a 15 percent marginal tax rate than for a 60-year-old in the 35 percent tax bracket.
As Congress works to reduce the deficit and find ways to keep Social Security and Medicare funded, the ICI believes it is important for people to understand how 401(k) taxation works.
"Americans overwhelmingly support the 401(k), and they support the tax incentives that help them to achieve their savings goals," McNamee said. "The U.S. retirement system is strong and is working for millions of Americans—but we can and should do more to build on its successes. "
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