NCPA - National Center for Policy Analysis

The 401(k) and IRA Tax Trap

January 31, 2002

Most people believe that saving in tax-deferred retirement accounts, such as 401(k) plans and traditional IRAs, will reduce their total taxes over their lifetimes. Yet according to a new study by the National Center for Policy Analysis (NCPA), these retirement accounts might actually cause low- and middle-income families to pay more in taxes.

For example:

  • If a couple earns $50,000 per year at age 25 and makes maximum 401(k) contributions over their work-life, their lifetime taxes will actually go up by more than $1,077 assuming a real rate of return of 6 percent (see Figure I).
  • At an 8 percent real rate of return, lifetime taxes would increase by more than $7,000.

If the federal government raises future tax rates -- which is very likely given the large unfunded liabilities in Social Security and Medicare -- 401(k) participants will do even worse.

The family would be better off avoiding the 401(k) deposit, paying taxes on the sum and investing it in a non-tax sheltered account. One reason 401(k) contributions increase the taxpayer's total taxes is the Social Security benefits tax. Although nominally a tax on benefits, it's actually a tax on other income.

"The Social Security benefit tax puts many people in a higher tax bracket after they retire than before," explains coauthor Laurence J. Kotlikoff. "So instead of paying taxes at the time of their life when they are in a lower tax bracket, 401(k) plans delay the payment until they are in a higher bracket."

Another problem is that large accumulations in a tax sheltered account mean large payouts during the retirement years, and this also pushes seniors into higher tax brackets. If less accumulates in the account, there will be less income and, therefore, a lower tax bracket during retirement.

Source: Jagadeesh Gokhale and Laurence J. Kotlikoff, "Tax-Favored Savings Accounts:Who Gains? Who Loses?"NCPA Policy Report No. 249, January 2002, National Center for Policy Analysis.

For text

http://www.ncpa.org/pub/st249

 

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