With the end of the year approaching, I suspect several people are considering whether to contribute or increase contributions to their 401(k)s. I still run into people confused about the merits of saving for retirement. People say things like, “By the time I retire tax rates are going to be much higher. Look at the national debt and the possible Trump spending plans on the horizon. Why should I pay taxes later at a higher rate when I can pay them at today’s low rate?”
This misconception about today’s rates vs tomorrow’s rates causes a lot of people to make poor decisions on whether to use tax-protected accounts, particularly during their peak earning years when the value of a tax deduction is at its greatest. Even if your firm doesn’t offer a 401(k) match, contributing to a 401(k) is like getting a free match from the government. It’s too good to pass up.
1) Today’s Tax Deduction
The most obvious value of contributing to a 401(k) is taking the tax deduction on today’s bill. Since the 401(k) dollars come off the top of your income, you save at your marginal rate. In other words, if my marginal rate is 33% (not including state and local taxes) and I contribute $18,000 to my 401(k), I save $5,940 on my taxes today.
People opposed to the 401(k) will quickly point out that you’re not actually saving the money. You’re just delaying when you will ultimately pay the taxes. For a 401(k), the amount will be taxed as ordinary income when you withdraw it in the future. If the tax rates are higher in retirement, you should have paid the tax today at the lower rate, right?
Not so fast.
First, there’s a benefit to having the extra money today. When are you more likely to need extra money in your life? Perhaps during your 20s when you’re in school and purchasing your first car. Or maybe it’d be nice to have in your 30s when you’re saving for a down payment. You probably could even use the money in your 40s and 50s when you are looking for extra cash to pay college tuition.
The truth is that dollars in your pocket when you are younger can often be put to great use as opposed to the pain of paying taxes in your 60s and 70s when you’ll have less overall expenses.
Plus, you’ve probably heard the phrase that a tax delayed is a tax not paid. It’s absolutely true! We have no idea what the tax situation will look like in 30-40 years. Maybe the US will have replaced the income tax with a flat national sales tax. Taking the tax savings today is a locked in benefit. Counting on a tax savings in the future is taking the risk that the rules will change.
2) Money Grows Tax-Free
If you have a taxable investment account, you’ve probably noticed how you get dividends and short-term capital gains distributed each year. These dividends are added to your taxable income each year and you pay a small tax. If you’re in the accumulating phase of life, it’s a bummer to have to pay taxes on these amounts today when you’re quite possibly at the highest marginal tax rate of your life. It’s not like you’re using/spending those dividends, right?
In a 401(k), you can accumulate those dividends and short-term capital gains without fear of paying taxes. This is known as eliminating the tax drag. Think the tax drag isn’t that significant? If you’re getting the market return of 7% on an index fund, which includes a 2% yield (i.e. 2% of the profits are distributed as dividends each year) and you’re paying 15% capital gains taxes, your real return is only 6.7%. On a $100,000 investment over 30 years, a 0.3% tax drag amounts to $61,492 in lost money. If you take advantage of the 401(k), you’ve eliminated the tax drag and will see a faster accumulation of your retirement funds.
3) Tax Rate Arbitrage
Perhaps the most important benefit of a 401(k) is taking advantage of the tax rate arbitrage. When you contribute to a 401(k), you save at your marginal rate (think of any contributions to your 401(k) as made with the last dollars you make each year). For example, if you’re in the 33% federal tax bracket, each dollar saves you $0.33 cents. Don’t forget to include state and local taxes too, which means you’re saving even more today.
Yet, when you withdraw the money later in life you will be paying taxes at your effective tax rate. What’s the difference? If your marginal tax rate is the amount of tax on the next dollar you earn, your effective tax rate is the amount of tax you pay across all of the dollars you earn.
If you’ve retired at 60 years old and are married taking the standard deduction and personal exemptions, the first $20,700 you withdraw from your 401(k) will be tax free. After that, you’ll only pay 10% taxes on the next $18,550 you withdraw.
Since you’re filling up the lower buckets with your 401(k) money, it’s easy to see that you’ll be paying a much lower blended tax rate on the withdrawals than the 33% you saved by making the initial 401(k) contributions. This is true even if tax rates go up substantially in the future, since there will presumably be lower brackets to fill first.
Saving taxes at 33% put paying them at a blended rate of 12% in the future is a winning bet you should make each and every time.
4) Tax Diversification
I’ve covered this in depth in a previous article, but don’t forget about the benefits of having diversified tax accounts in retirement. If all of your money is in a taxable account, it’s great that you won’t have to pay any future taxes when you withdraw the money, but you’re leaving money on the table by not being to pick and choose from different accounts.
For example, as discussed above, you can withdraw up to $20,700 a year tax free from your 401(k). If you have taxable or Roth accounts that can make up the difference between that amount and your living expenses, you effectively have avoided ever paying taxes on the money in your 401(k). That’s a pretty good deal! Do yourself a favor and give yourself options in the future to diversify your withdrawals to take advantage of the tax code.
The takeaway? If you’re in your peak earning years, you should be taking advantage of every tax-deferred account available to you.
Joshua Holt is a practicing private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He knows that the Bogleheads forum is a great resource for tax questions and is always looking for honest advisors that provide good advice for a fair price.