NCPA - National Center for Policy Analysis

How 401(k) Plans May Increase Lifetime Tax Burden

July 24, 2001

401(k) retirement plans have become America's favorite way of saving for retirement, and tax deferral is one of its most significant features. However, Boston University economist Larry Kotlikoff and two economists from the Federal Reserve Bank of Cleveland say that 401(k) savings can actually increase an individual's lifetime tax burden, compared to saving the money in a taxable money-market account or mutual fund.

How can this be?

  • Social Security benefits are subject to taxes, and the draw down of large sums at retirement provided by the 401(k) can kick people from the bracket in which 50 percent of benefits are taxable into one in which 85 percent are taxable.
  • Making contributions to a 401(k) plan can put a worker in a lower tax bracket but also reduces the value of his tax deductions, say for mortgage interest or children.
  • Children also cost 401(k) contributors in the long run because paying out large sums for college leaves so little cash at retirement that people withdraw more from their savings -- thus triggering the higher taxes on their Social Security benefits.

The biggest losers are those who contribute the maximum amount into their plans, and make less than $200,000. Take a family or worker earning $50,000 in 2000 and putting the maximum in a 401(k) plan that earns 8 percent a year.

  • That worker or family would end up raising their lifetime tax payments by 6.38 percent, and reducing their after-tax income by 1.73 percent.
  • For a retirement nest egg of $300,000 that's supposed to last 20 years, this would reduce average retirement income from $15,000 a year to $13,800.

The news is worse for someone putting the maximum in a 401(k) and earning $25,000 in 2000. When combined, the lifetime tax and spending loss is just shy of 11 percent of income.

Source: John Maggs, "And You Thought 401(k)s Were A Safe Bet," National Journal, July 7, 2001; based on Jagadeesh Gokhale, Laurence J. Kotlikoff and Todd Neumann, "Does Participating in a 401(k) Raise Your Lifetime Taxes?" Working Paper 01-08, Federal Reserve Bank of Cleveland, June 2001.


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