A common concern when contributing to retirement accounts is that you’re not actually avoiding taxes, you’re simply deferring them to some time in the future.
This confuses a lot of investors, causing them to misunderstand the value of retirement accounts.
Some typical questions might be:
Are you really getting a good deal if you save 33% on your taxes today but pay the same tax rate in the future? Seems like a wash.
Plus – what if tax rates go up dramatically? You can’t predict future tax brackets! You could be taking a tax break today at 33% but paying a tax rate of 40% in the future. Shouldn’t you take the tax hit you know today vs hoping that it’ll work out in the future?
But there are several advantages to retirement accounts that override these concerns.
(1) The 401(k) Match
If your employer offers you a match, you should take it. For example, you might have a deal where your employer contributes 100% of the amount you contribute up to a certain ceiling. Let’s imagine that’s $3,000. You put in $3,000 and your employer puts in $3,000. That’s a 100% return. You will never see that kind of return anywhere else. Take it.
But many lawyers don’t get any kind of match (or are partners and are matching with their own money anyway), so let’s forget about the match even if it is an obvious advantage for certain people.
(2) Time Value of Money
There’s a common phrase that you’ll do well to remember: a tax delayed is a tax not paid.
Is it strictly true? Of course not! You’re simply deferring taxes into the future.
But is it effectively true? Absolutely. A tax delayed is a tax that you’re not paying today.
The future is uncertain and that uncertainty cuts both ways.
Will you pay that tax in the years ahead? You might. Or you might not. Maybe there will be future tax breaks or other ways to minimize or eliminate the tax. Who can say?
But even if you do pay the tax in the future, you will be paying the tax with cheaper dollars. That’s because a dollar today is worth more than a dollar in the future. That’s the time value of money. A simple example will help explain it.
Example 1. Larry has to pay a 10% tax on $1,000 of income, meaning he owes the IRS $100. The IRS gives him two options: Pay the $100 today or pay the $100 in three decades. Thanks to inflation, we can calculate that the present value of $100 in 30 years is approximately $41.20 today (assuming 3% inflation). In other words, you could set aside $41.20 today earning 3% and have $100 in 30 years to pay the tax bill. The decision between paying the IRS $100 today or setting aside $41.20 and paying the IRS in 30 years is obvious.
So, a tax delayed is definitely worth something just by itself even if the tax rates stay the same. If you’re really rich, you probably have a whole team of accountants and lawyers trying to figure out ways to delay your tax payments. You might even be able to delay it indefinitely if you delay the tax payment until your death and leave your assets to your heirs with a step up in basis. In that case, the tax is never paid.
(3) Marginal vs Effective Tax Rate
The slightly more complicated point to understand (although it makes obvious sense once you get it) is that when you defer taxes through a contribution to a retirement account you save on your marginal taxes today and you pay at your effective tax rate in the future.
Let’s run through another quick example.
Example 2. Larry has a marginal tax rate of 45.6% (federal, state and city taxes). He contributes $10,000 to a retirement account and saves $4,560 today ($10,000 x 45.6%). Let’s assume he withdraws the money in 30 years and it didn’t earn a dime. Will he have to pay 45.6% on the $4,560 in his retirement account? Highly unlikely. His first $10,350 is tax-free thanks to the personal exemption and standard deduction. The next $18,550 are taxed at 10%. It would be very difficult for Larry to pay 45.6% tax on the money withdrawn in retirement. He’d need a huge income in retirement pushing his retirement tax rate all the way up to 45.6%. We should all be so lucky to retire with such problems!
If Larry saves money at 45.6% and then withdraws it in the future at a blended effective tax rate of 24%, he ends up saving about 21.6% (45.6% – 24%) on his contribution or about $2,160 of the original $10,000 contribution. That’s equivalent to a 21.6% immediate return on your money.
Where else are you going to find a return like that?
Of course the numbers I used in the calculation might be different from your numbers. They’re also probably different from future tax rates. So what? Even if the numbers are off by half, you’ve still got an automatic return of 10.8%.
The benefits of retirement accounts are too good to pass up.
This is even magnified if you end up earning money in a high-tax location/state and then retiring to a low or zero income-tax state.
What kind of people work in urban centers in high growth states with high tax rates? Why, lawyers of course!
Where do those lawyers like to go when they retire? To warm weather locations with low or zero taxes like Arizona and Florida!
If that’s you, you’ll be able to skip paying the city and state taxes entirely on the money in your retirement account.
(4) Tax-Free Growth
As if the benefits of saving taxes at your marginal rate and paying them at your effective rate weren’t good enough, there’s also the benefit of having your investment grow tax-free during your earning years.
Every time an investment is sold in a taxable account you have to pay capital gains taxes on the sale. The capital gain taxes apply to your dividends and capital gain distributions too, causing a drag on your portfolio, so even if you’re in a low-drag investment like an index fund you’ll still see a lower growth rate.
Example 3. Larry has $10,000 invested earning 8% a year in the market but 2% of his return is attributable to dividends which are taxed at 15%. That means Larry’s actual return, after taxes, is 7.7% (2% x 15% = 0.3% which is paid to the IRS).
The 0.3% paid in taxes may not sound like much but over 30 years it will result in tens of thousands of dollars that are lost.
Compare this to a 401(k) account where the money would grow tax-free (at the full 8% in our hypothetical) and you’ll see that going with the 401(k) is a clear winner over the taxable account. Sure, you won’t get all of that 0.3% for yourself, since you’ll eventually have to pay taxes on it, but you’ll keep the lion’s share of those gains and only a relatively small percentage will go to the government.
The Downsides of Retirement Accounts
There are a few downsides of retirement accounts that worth mentioning. Many 401(k) accounts, for example, are often loaded down with unnecessary high fees and expenses. You can select low-cost index funds to reduce those fees but there usually isn’t much you can do to reduce the bottom line fees charged by the 401(k) administrator.
These costs and fees add up over time, unless you change jobs and roll that money into a low-cost institution like Vanguard. But either way, 401(k) costs and fees take a toll on your investment return. Even someone who is paying attention to the fees might end up spending 0.5% per year in 401(k) administration fees.
While these fees are unfortunate, they are dwarfed by the savings that we’ve calculated above. The only time the math starts to work out poorly is if you’re 401(k) is charging 1.5-2% annual fees. Even really bad 401(k) plans have options for low-fee investors and based on what I’ve seen in my review of law firm 401(k) plans, you are likely to find low cost options that can keep your total fees well below that threshold.
Finally, I’ve heard some people complain that you can’t take advantage of tax-loss harvesting inside a retirement account. That’s true. So what? You should max out retirement accounts first anyway before you start filling your taxable account. Contributing to taxable accounts as a priority over retirement accounts just to be able to take advantage of tax-loss harvesting strikes me as a pretty foolish move.
Let’s talk about it. Are you convinced that retirement accounts save you money on your taxes? I hope so, otherwise my writing and persuasion skills need a lot of work! These things should sell themselves! Leave a comment below.