Tax-Favored Savings Accounts: Who Gains? Who Loses?

Policy Reports | Taxes

No. 249
Thursday, January 31, 2002
by Jagadeesh Gokhale and Laurence J. Kotlikoff

401(k) Participation and the New Tax Law

Table I - Change in Present Value of Lifetime Taxes from 401(k) Participation

"Because of the Social Security Benefits tax, many families will be in a higher tax bracket after they retire."

This study uses ESPlannerTM (Economic Security Planner), developed by Economic Security Planning, Inc., to calculate the gains or losses from contributing to tax-deferred and non-tax-deferred retirement accounts. ESPlanner is a proprietary life-cycle financial planning model with highly detailed tax and Social Security benefit calculators. [See the appendix for more details.] Applying ESPlanner to representative households generates some surprising conclusions.

The following tables assume married couples make the maximum contribution to 401(k) accounts and earn the same real rate of return on investments inside and outside the accounts. (Additional assumptions about the couples' spending and saving decisions are discussed in the appendix.) The tables show the tax consequences of depositing pretax income in 401(k) accounts over a worklife and paying taxes on withdrawals during the retirement years versus realizing an equivalent sum as income, paying taxes as the income is earned and investing the remainder in a non-tax-sheltered account. Investment income from the non-tax-sheltered account is assumed to be taxed at ordinary income tax rates, rather than at capital gains tax rates. For this reason, the comparison is very conservative - one that favors the 401(k) account option.

The tables show the present value of the change in total lifetime federal income and payroll taxes and state income taxes as a result of choosing the 401(k) investment option. Present values are expressed in year 2000 dollars and are calculated using the same rate of return assumed to be earned in the 401(k) account.

"A couple earning $50,000 annually pays higher lifetime taxes with a 401(k) plan."

Effects on Average-Income Families. Consider a typical 25-year-old couple that initially earns $50,000 (each spouse earns $25,000) and makes the maximum contribution to its 401(k) plans. The table [ See Table I ] shows the impact on the couple's lifetime taxes assuming it earns real rates of return of 4 percent, 6 percent or 8 percent on investments inside and outside the 401(k) accounts. As the table shows:

  • Rather than lowering their lifetime taxes, 401(k) participation raises the couple's lifetime tax payments by $1,077 if the couple earns a 6 percent real rate of return.
  • The lifetime tax hike is $7,112 if the couple earns an 8 percent real rate of return.
  • In fact, the couple only gains from 401(k) participation if its return is relatively low; for example, at a 4 percent real rate of return, choosing the 401(k) option lowers lifetime taxes by more than $11,000.
Table II - Change in Present Value of Lifetime Taxes from 401(k) Participation Assuming 20 Percent Higher Tax Liability After Retirement

"Unfunded federal liabilities mean future taxes will likely be higher."

These results do not mean that low rates of return are better than high ones. To the contrary, other things being equal, a high rate of return is always better. Instead, the results show that if the couple invests in a largely stock portfolio, both within and outside of its 401(k), with the purpose of earning the long-run return paid by the capital market as a whole, it does better paying taxes on income as it is earned and avoiding the 401(k) option. The reason: a high rate of return means more accumulation and, therefore, larger withdrawals and higher tax brackets during the retirement years. Only if this couple plans to make very conservative investments (say in government bonds) does saving significant sums in a 401(k) plan make sense.

Effects of a Post-Retirement Tax Hike on Average-Income Families. The picture becomes even bleaker if taxes are increased by 20 percent when the couple retires - a very realistic possibility given the federal government's enormous unfunded liabilities in Social Security and Medicare. As Table II shows:

  • With a 20 percent higher tax liability during their retirement years, the couple's loss from 401(k) participation rises to $8,680 if their contributions earn a 6 percent rate of return.
  • At an 8 percent rate of return, the couple can expect to pay $13,574 more in taxes because of 401(k) participation.

Effects on High-Income Families. In general, high-income families unambiguously gain from the "A couple earning $30,000 per year can save $125,000 in taxes from 401(k) participation."
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 assuming a 6 percent return.
  • The couple also realizes a hefty gain (more than $100,000) even if taxes during its retirement years are 20 percent higher.
Table III - Percentage Change in Lifetime Taxes from 401(k) Participation%3A Alternative Assumptions about the Contribution Tax Credit

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 their 401(k) investments.
  • And if taxes are hiked by 20 percent during their retirement years, the couple's loss climbs to more than $14,000.

Effects on Low-Income Families. As noted above, the new tax law provides low-income families with significant non-refundable tax credits. But the effect of the tax credits is difficult to calculate because it depends on how long the credit lasts and how much inflation erodes its provisions. The law states the credit will end in 2007, with no (inflation) adjustment to the nominal income levels at which it is phased out. If these provisions are retained, the tax credit will do little to nullify the lifetime tax hike low-income households potentially face from participating in tax-deferred retirement plans.

"Low-income families increase their tax burden if they save too much through IRAs."

Table III illustrates three different assumptions about the evolution of the new contribution tax credit, assuming a 6 percent rate of return. The first is that the law is not changed, so that the credit is terminated after 2007. The second is that the credit is extended, but the thresholds for the credit are not indexed for inflation. And the third is that the credit is extended indefinitely and the thresholds are indexed for inflation.

For the couple earning $25,000, the credit does not help enough to make 401(k) participation attractive. If the credit is made permanent and indexed for inflation, 401(k) participation becomes largely a break-even proposition, netting them a meager $420 gain. The magnitude of this gain is unlikely to compensate for a 40-year loss of liquidity, however. (Any withdrawals prior to age 59 ½ are subject to normal income taxes plus a 15 percent penalty.) The reason the credit does relatively little for this couple, even if extended and indexed, is that the credit is available only to the extent that taxes are actually paid. Since each year's available credit exceeds the couple's tax liability for that year, the couple never enjoys the full advantage of the credit.

If the couple starts out earning $35,000, the credit is more effective because the couple has more taxes against which the credit may be offset. Indeed, even if the credit is only temporary, the $35,000 couple will still break even from 401(k) participation. If the credit is made permanent and indexed, the couple will enjoy a 2 percent decrease in lifetime taxes as a result of 401(k) participation.

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