Tax-Favored Savings Accounts: Who Gains? Who Loses?
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Recent legislation greatly expands the limits on tax-deferred savings accounts, including 401(k) plans and IRAs. This legislation is the latest in a quarter century effort by the federal government to convince Americans that saving through tax-deferred retirement accounts results in lower lifetime taxes.
The premises behind tax deferral are the beliefs that people (a) will be in a lower tax bracket during their retirement years than during their working years and (b) will in effect have an interest-free loan on tax payments. Therefore, tax deferral represents an opportunity to avoid taxes when the rate of taxation is high and pay them when the rate is low. Twenty-five years ago this assumption was probably valid. But for millions of low- and moderate-income families today, the assumption is no longer true. Instead:
- The federal income tax levied on Social Security benefits will cause many low- and moderate-income families to face higher tax rates after they retire.
- Large accumulations in tax-free savings accounts, which will be withdrawn and taxed during retirement, will push taxpayers into even higher tax brackets.
- As a result, millions of American families will actually increase their lifetime tax burden if they take full advantage of tax-deferred savings opportunities.
Consider a 25-year old, two-earner couple with an annual income of $50,000:
- If the couple makes the maximum contribution to a 401(k) account permitted by the typical plan every year and earns a 6 percent real rate of return on its investments, its lifetime taxes will actually increase by $1,077 (measured in year 2000 dollars).
- If the couple earns an 8 percent return, its lifetime taxes will rise by $7,112.
- If taxes during the couple's retirement years are increased by 20 percent - a realistic possibility given the large unfunded liabilities in Social Security and Medicare - the lifetime tax hike climbs to $8,680 assuming a 6 percent return or $13,574 assuming an 8 percent return.
- In all cases, the couple would be better off not participating in the 401(k), paying taxes on the income as it is earned, and investing the funds directly!
Ironically, the only way the couple can gain through 401(k) participation, if it earns moderate to high rates of return on its savings, is if it contributes less than what the typical plan allows. A similar principle applies to individual retirement accounts. For example:
- If each spouse deposits $2,000 per year into an IRA, the couple's lifetime taxes will be reduced by more than $6,000 (6 percent return).
- But if the couple takes advantage of the new law and deposits $5,000 per year in its IRAs, it will be worse off - paying more than $5,000 in additional taxes as a result of the effort.
Low-income families get a slightly better deal because of another provision in the new tax law: the federal government partially matches contributions these families make to retirement accounts. However, in the case of contributions to 401(k) and other tax-deferred retirement accounts, the benefits of this gift are not enough to offset the negative effect of higher post-retirement tax rates, at least as the law is now written. Even if low-income families take full advantage of the new 401(k) opportunities, they gain only if: (1) the matching program is extended beyond its current expiration date, (2) the qualifying income limits are indexed for inflation and (3) taxes are not substantially increased after they retire.
The prospects are even worse for low-income families who take advantage of the higher limits on IRA deposits, even if the government's matching program continues throughout their working years. For example,
- Consider a couple earning $35,000 per year; if each spouse were to contribute $5,000 per working year, which is the maximum IRA contribution that will be permitted as of 2008, the couple's lifetime taxes would rise by more than $10,000.
- A couple earning $25,000 per year is entitled to receive a larger matching contribution. But despite this bonus, if the couple takes full advantage of the new IRA opportunities it will pay more than $23,000 in additional lifetime taxes!
In general, high-income families unambiguously gain from the opportunity created by the new tax law. For example:
- A couple earning $300,000 a year receives a lifetime benefit of more than $125,000 from making the maximum yearly contributions to 401(k) accounts (6 percent return).
- The couple still realizes a very hefty gain (more than $100,000) even if taxes during its retirement years are 20 percent higher.
But the same may not be true of the moderately well off. For example,
- A couple earning $100,000 a year can expect a slight increase in lifetime taxes if it earns an 8 percent real return on its 401(k) investments.
- And if taxes are hiked by 20 percent during its retirement years, the couple's loss climbs to more than $14,000.
Fortunately there is a fairly simple solution - one that would encourage saving without unfortunate tax surprises during the retirement years. The solution is to promote the use of Roth IRAs by low- and middle-income households. Deposits to Roth IRAs are made with after-tax dollars. But during retirement, withdrawals are tax-free. Every income group would benefit from taking advantage of this form of taxation. But it is especially beneficial to low- and moderate-income families who, if they save on a tax-deferred basis, can expect to face higher tax rates after they retire.