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Evaluating Retirement Strategies: What if income tax rates go UP?

2 March, 2017

In any discussion regarding the financial issues that face the American government, one of the default responses is finding ways to increase income tax revenues.  While some economists may postulate the counter-intuitive idea that lower tax rates often result in higher revenues (and there is some historical support for this perspective), the straightforward approach typically favored by legislators is to increase tax rates and/or eliminate deductions.  The year 2013 has already seen some income tax increases, and the challenge of resolving the accelerating trajectory of the federal debt makes additional proposals for income tax increases a near certainty.

Given the increasing possibility of higher marginal tax rates, how should individuals evaluate their future participation in qualified retirement plans?  Is it better to make pre-tax 401(k) deposits today, and pay taxes on the distributions when the money is used for retirement?  Or does it make sense to use a Roth 401(k) and incur the tax cost now – even with higher tax rates – knowing future distributions will be tax-free?

In any tax environment, answering the question of “taxing the seed or the harvest?” is a critical decision point.  However, a purely financial answer to this question hinges on unknowable future conditions:  What will tax rates be at retirement?  If tax rates are static, there is no advantage to pre-tax or after-tax qualified retirement plans (See Fig. 1).  This means individual savers must either resolve the pre-tax/after-tax question by guessing their future tax rates – or by using different criteria to make their decision.

The Changing Landscape of Retirement Plans

Twenty years ago, the pre-tax/after-tax discussion didn’t exist because all qualified retirement plans were configured in pre-tax formats: Deposits, up to specified limits, were exempt from immediate taxation, and allowed to accumulate tax-free.  At distribution (typically after age 59½), any withdrawals would be taxed as regular income. The logic for pre-tax saving was simple: Because it was assumed one’s retirement income would be less than when working, distributions would be taxed at a lower rate.

The grand-daddy of pre-tax retirement plans was the Individual Retirement Account (IRA), authorized by Congress in the mid-1970s.  As the popularity of this format spread, it spawned other variations, including the 401(k), which is today the prevalent employer-sponsored qualified retirement plan.

However, the three decades since the advent of pre-tax retirement saving have shown that the assumption of lower taxes in retirement may be invalid.  First, tax changes in the 1980s “flattened” marginal tax rates; the number of tax brackets between “high” and “medium” income levels were reduced, making it less likely that a decrease in income at retirement would result in a lower tax rate.  Second, the lifestyle patterns of successful savers often meant that tax deductions taken during their working years (for dependents, mortgage interest, etc.) were no longer available in retirement; the house was paid for, and the kids had moved out.  A flatter tax structure, and the absence of deductions, combined with substantial accumu-lations, frequently results in a higher tax paid on distributions compared to the savings on the pre-tax deposits.

Recognizing this higher-tax-in-retirement scenario might discourage retirement saving, Congress established Roth IRA accounts in 1998.  In the Roth format, deposits are made with after-tax dollars, and, similar to IRAs, allowed to accumulate tax-free.  The big difference: distributions are free from income tax, as long as the funds have been in the account for five years, and the account holder is over 59½.  In 2001, additional legislation expanded the Roth format to permit employer-sponsored plans, beginning in 2006.

Today, it is possible for employers to offer both pre-tax -401(k) - and after-tax - Roth 401(k) retirement accumulation plans. Although some features are dependent on the provisions elected by the employer, employees can contribute to both types of plans in the same year, provided total contributions don’t exceed the annual threshold ($17,500 in 2013).  Additional changes in 2010 expanded 401(k)/Roth 401(k) options to include conversions of existing pre-tax 401(k) balances to Roth 401(k) status by paying the tax now. The American Taxpayer Relief Act of 2012 (ATRA) also further expanded options to convert.

The February 9, 2013, Wall Street Journal (“More Firms Roll Out Roths”) reported that only half of employers currently offer Roth 401(k) options alongside their regular 401(k)s. However, more than one-fourth of those 401(k)-only companies were planning to introduce Roth 401(k) options in the coming year. As a result of these changes, many individuals will be facing two questions: 

  1. Going forward, how should I save for retirement – pre-tax or after-tax?
  2. Should I convert my pre-tax savings to after-tax status? 

It should be noted that 401(k)-to-Roth 401(k) conversions are subject to some precise terms and conditions and may result in significant tax consequences. But whether the question is new deposits or re-characterizing existing accounts, the issue remains the same: pay tax on the seed or the harvest?

As was illustrated earlier, the mathematical assessment of the pre-tax-vs-after-tax decision is dependent on a projection of future tax rates.  But no matter how optimistic or cynical your view of governmental decision-making, there is no way to divine future tax policies and their impact.  So…

Given the absence of any reasonable mathematical paradigm on which to make a decision, some individuals may operate from a different premise: select the option that offers a higher level of financial certainty.  Most business owners will say financial certainty – even the certainty of higher costs or lower profits – gives them a planning advantage. Certainty in one aspect allows others to be adjusted, and clarifies the steps needed to address future challenges. Individual savers are no different.

If you select a Roth format, the current tax costs, while perhaps steep, are known quantities.  And so is your future tax status – distributions are tax-free.  In contrast, a decision to defer the tax on a 401(k) offers clearly-defined up-front tax savings, but introduces future financial uncertainty, because the cost of taxation won’t be known until the money is withdrawn. Who knows what those costs will be, and how they may affect your ability to enjoy the distributions?

Considering the regularity with which Congress alters the tax code, a 20- or 30-year period between deposit and withdrawal exposes one’s pre-tax retirement account to a lot of potential tax changes.  Since the money has yet to be taxed, it is easier for Congress to rationalize adjusting the distribution terms for pre-tax accounts.  For after-tax savers who have already paid the tax according to current law, it is conceivable that future legislation could revoke the tax-free status of both accumulations and withdrawals from Roth accounts.  But the political fall-out would undoubtedly be far greater; it would appear the government was breaking faith with account holders by taxing them twice.

For committed savers with longer time horizons (20 years or more), the financial certainty of paying tax today may be more desirable than waiting for the tax hammer of unknown force to fall in retirement.  But the challenge to choosing the long-term financial certainty of a Roth account may be affordability.  If your marginal tax rate is 30%, and the goal is to deposit $10,000 a year toward retirement, gross earnings must be $14,285 to net a $10,000 after-tax Roth deposit.  A pre-tax saver using a 401(k) needs only $10,000 – and the willingness to take the risk of whatever the future tax cost will be.

Conversely, savers with high current income, limited retirement assets, and shorter time frames may find greater certainty in pre-tax deposits. With a shorter accumulation period and a greater disparity between anticipated retirement and pre-retirement income, the prospects of retiring into a lower tax bracket increase.  It may be an over-simplification, but under-achieving savers stand to benefit most from pre-tax plans while after-tax plans probably favor “prodigious accumulators of wealth” (a phrase coined by William Danko in The Millionaire Next Door).    

Are there other tax-free accumulation alternatives?

The most attractive feature for both pre-tax and after-tax retirement plans is the tax-free growth during the accumulation period.  This allows for maximum compounding, as gains are not diminished by annual taxes on dividends or capital gains.  However, both pre-tax and after-tax qualified retirement plans impose penalties on early distributions (i.e., prior to age 59½), and both types of plans are constrained by annual contribution limits.  But suppose your financial plans include objectives with shorter time horizons, or a particularly profitable year means additional dollars for investment.  Are there other tax-free accumulation options?

With careful planning, it is possible to construct a tax-favored accumulation program outside of a qualified retirement plan.  Many municipal debt instruments issued by local and state governments have tax-favored benefits in regard to interest payments.  Life insurance cash values allow for inside buildup without tax and, under specific terms, may be withdrawn or borrowed on a tax-free basis. When shares of stock and real estate holdings appreciate, the growth is tax-free, with a capital gains tax due only upon the sale of the asset. These alternative products have unique benefits as well as limitations, so expert assistance is recommended. But, depending on your individual circumstances, non-qualified accumulation instruments may either complement or surpass qualified retirement plans as vehicles for tax-favored accumulation.

Beyond the specifics of pre-tax/after-tax or qualified/non-qualified accumulation programs, higher taxes compel consumers to stay on top of their allocation decisions.  Taxes not only diminish immediate returns, but also exact ongoing opportunity costs. The sooner you start accumulating on a tax-favored basis, the better.