A note on retirement saving tax benefit

We have found that, for many (including many experts), the retirement savings tax benefit is not particularly intuitive. In this note we discuss it in detail and with illustrations.

We are going to focus on the (non-Roth) 401(k) tax benefit – how much a taxpayer saves in taxes if she saves, e.g., $18,000 (the 2016 maximum, disregarding catch-up contributions) in a 401(k) plan or, alternatively, saves it outside a plan. But the principles generally apply to all tax qualified retirement savings.

And we are only going to focus on the benefit the taxpayer gets when the tax rate at contribution and the tax rate at distribution are identical. (The tax benefit from being able to shift income from a high tax year to a low tax year is relatively intuitive.)

Under current rules, a 401(k) contribution is taxed as follows:

(1) The contribution is excluded from the participant’s taxable income at the time of contribution;

(2) Earnings accumulate tax-free (generally, in a tax-exempt trust); and

(3) The contribution and earnings are taxed as ordinary income when distributed.

Under this system (and our assumed constant tax rates), the tax benefit is, and is only, item (2), the tax-exempt trust earnings. And that benefit is equal to the tax that would otherwise be paid on investment earnings outside the plan.

Oversimplifying, currently, for taxpayers in the highest income tax bracket, the tax on non-tax qualified investment earnings is 23.8% – 20% capital gains/dividends tax plus 3.8% Medicate Net Investment Income tax. (For a more nuanced discussion of the tax on investment earnings, see the sidebar.)

Sidebar:

The tax on investment earnings. Under current rules, the taxation of investment earnings not held in a qualified plan is somewhat complicated. Currently there is a lower tax on realized qualifying capital gains and dividends. The amount of that lower tax depends on your tax bracket: (1) taxpayers in the 10% and 15% brackets pay no capital gains/dividends taxes; taxpayers in the 25%-35% brackets pay at a 15% rate; and taxpayers in the 39.6% bracket pay at a 20% rate. The 3.8% Medicare net investment income tax is only applicable to certain high-income taxpayers, e.g., joint filers with adjusted gross income over $250,000. Further complicating analysis, the capital gains and the Medicare NII taxes are only paid on realized capital gains. So it is possible to defer taxation using a buy-and-hold strategy. A buy-and-hold strategy would marginally reduce the tax effect of saving outside a plan, but generally that reduction is not significant.

In the analysis in this article, with respect to the taxes on investment income, we make two simplifying assumptions: we assume no interest income and that capital gains are realized once a year.

We demonstrate the basic principle – that the tax benefit is, and is only, the tax-exempt trust earnings – in Illustration 1 (the Illustrations appear at the end of this article).

Now, let’s consider some of the implications of this basic principle:

The benefit accrues to even short-term in-plan savings. Some believe, because in-plan earnings are taxed, when distributed, at ordinary income tax rates, that saving in a plan for a short period of time is less tax efficient than saving outside a plan and paying, e.g., capital gains rates. That is not true. As long as outside-the-plan earnings are subject to tax, investing in a plan for only one year still generates a tax savings. We demonstrate this in Illustration 1 (See Below).

The tax exclusion (sometimes thought of as a deduction) has no value. Imagine a world in which there were no tax on investment income – Senator Rubio (R-FL) actually made such a proposal in the Republican primary campaign. In such a system, there would be no tax benefit to saving in a qualified plan (assuming constant tax rates). Taxpayers saving outside a plan would pay taxes immediately, and then the earnings on their savings would be un-taxed. Taxpayers saving inside a plan would, on distribution, pay taxes on savings plus earnings. This is just an illustration of the associative property of multiplication. You can reduce the contribution amount for taxes, then invest it, or you can invest it and then reduce it for taxes. It doesn’t matter what order you do that the operations in: invest/earn/tax yields the same result as tax/invest/earn. I x E x T = T x I x E. We demonstrate this in Illustration 2 (See Below).

A higher income tax rate does not equal a higher retirement savings tax benefit. Most of the retirement savings tax benefit is generated by, as we have said, the amount of the tax on investment income. It turns out – and this is probably the least intuitive result of this analysis – that, assuming identical taxes on investment earnings, a taxpayer paying a lower income tax benefit gets a (marginally) greater tax benefit from in-the-plan savings. In Illustration 3 (See Below), we compare two taxpayers who pay identical capital gains/dividends rates (15%) but different income tax rates (35%/25%), and demonstrate that, all other things equal, the taxpayer paying the 25% rate gets a greater retirement savings tax benefit. The best explanation of this result is that, outside the plan, a 25% taxpayer has more (after paying income taxes) left over to invest (than the 35% taxpayer), generating more earnings and therefore more capital gains/dividends taxes and thus, alternatively, greater tax savings by saving in a qualified plan.

What the forgoing analysis does not take into account

In this analysis we have restricted discussion to the case in which the taxpayer is paying the same income tax rate at contribution and distribution and have ignored the possibility of Roth contributions. This leaves out several issues.

401(k) plans (and qualified retirement savings generally) can permit the taxpayer/participant to shift income from a high tax year to a low tax year. The tax benefit from this can be significant and can vastly outweigh the tax benefit from the non-taxation of qualified plan trust income. We have not discussed this benefit because it’s pretty easy to understand: getting a “deduction” (actually, a tax exclusion) when you are paying taxes at, e.g., a 39.6% rate, and then paying taxes on the distribution when you are paying taxes at a 25% rate, is an obvious (and powerful) tax benefit.

We would also note that, as we discussed in our article House Republican tax and retirement policy proposals, comprehensive tax reform, fundamentally changing the current income tax rate structure, is unlikely unless one party controls the White House and both houses of Congress and makes tax reform a legislative priority. If that does not happen, then, as we discuss in our article Corporate tax reform and retirement savings tax policy, a change to the corporate tax that also changes how investment income is taxed is more likely. In that event, the retirement savings tax benefit we have described in this article may be “in play.”

Roth contributions provide several advantages vs. non-Roth contributions. First, because Roth contributions are made on an after-tax basis, the maximum contribution is, effectively, higher. Second, Roth IRAs are not subject to the required minimum distribution rules during the life of the owner – lengthening the period in which assets can be held in the trust/IRA, exempt from the taxation of earnings.

Finally, we have only focused on the issue of retirement income. If the objective is, e.g., providing a legacy, there may be situations in which outside-the-plan investments produce a better tax result.

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The basic principle here is simple: assuming constant tax rates, under the current system the value of the retirement savings tax benefit is determined by the (alternative) tax on investment income, which investors in a qualified plan do not pay. There is so much focus, however, by participants and even policymakers, on the initial exclusion from income, that the simplicity of this principle is often lost. Keeping a focus on this principle will be important as we consider, e.g., proposals to change the taxation of investment earnings, either as part of comprehensive tax reform proposals or corporate tax reform proposals.

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Illustrations

For purposes of all illustrations we assume:

Contribution: $18,000Earnings rate: 3.00%

Illustration 1 – the tax benefit is, and is only, the tax-exempt trust earnings

Assumptions:

Years in plan: 1IT rate at contribution: 39.6%CG/Div tax rate: 20%IT rate at distribution: 39.6%Medicare NII rate: 3.8%

One individual contributes $18,000 to a plan and leaves it there for 1 year at a 3% earnings rate. During that year the $18,000 earns $540. She receives a distribution of $18,540, which is then taxed at a 39.6% rate. At the end of the period, she has $11,198.

Another individual takes the $18,000, pays taxes on it (at 39.6%), and contributes the remaining $10,872 to a brokerage account where it earns 3% = $326. He pays taxes on those earnings at a 23.8% rate (capital gains + Medicare NII taxes) of $78, leaving him with $248. At the end of the period, he has $10,872 + $248 = $11,120.

The difference between those numbers – the difference between what the inside the plan saver has ($11,198) and what the outside the plan saver has ($11,120) – is $78, exactly equal to the tax on investment earnings that the outside the plan saver paid and the inside the plan saver didn’t pay.

Illustration 2 – the tax exclusion has no value

Assumptions:

Years in plan: 1IT rate at contribution: 39.6%CG/Div tax rate: 0%IT rate at distribution: 39.6%

One individual contributes $18,000 to a plan and leaves it there for 1 year at a 3% earnings rate. During that year the $18,000 earns $540. She receives a distribution of $18,540, which is then taxed at a 39.6% rate. At the end of the period, she has $11,198. Another individual takes the $18,000, pays taxes on it (at 39.6%), and contributes the remaining $10,872 to a brokerage account where it earns 3% = $326. At the end of the period, he has the same amount, $11,198.

Illustration 3 – a higher income tax rate does not equal a higher retirement savings tax benefit

Assumptions:

Years in plan: 1IT rate at contribution: 35%/25%CG/Div tax rate: 15%IT rate at distribution: 35%/25%

Taxpayers in the 25%-35% brackets pay different income taxes but the same capital gains/dividend taxes (we disregard the possible application of the Medicare NII tax). As the above numbers illustrate (in operations more or less the same as Illustration 1), the taxpayer in the lower tax bracket actually saves more in taxes by saving in a tax qualified plan.