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ICI’s Guide to Avoiding a Common 401(k) Tax Trap
By Mike McNamee
There’s a tax trap for retirement savings that is catching many smart people unaware. If allowed to go unchecked, it could harm the retirement savings of millions of Americans. A columnist for the Washington Post was just the latest in a long list of victims.
This trap, however, has nothing to do with IRS rules. It boils down to a basic misunderstanding about how the tax incentives for 401(k)s and similar retirement plans work. The trap is the notion that the tax treatment of 401(k)s benefits only the wealthy—or, more broadly, that the benefits are driven by a saver’s tax bracket.
As we near the start of a new year, we invite you to learn the facts about tax deferral—and join us in the pledge to let the facts guide any debate over retirement taxation in 2014.
An Important But Poorly Understood Benefit
The problem arises from a basic misunderstanding of tax policy. The tax treatment of retirement savings—tax deferral—is often lumped together with tax deductions (such as the deduction of mortgage interest expense from income) and tax exclusions (such as the exclusion of employer-provided health insurance premiums from income).
But a deferral of tax is neither a deduction nor an exclusion. Tax deferrals reduce taxes paid in the year of deferral, but increase taxes paid in the year that the income is recognized. Deductions and exclusions, on the other hand, reduce taxes paid in the year they are taken—period. Because of this difference, the benefits of tax deferral cannot be calculated in the same manner used to determine the benefits of an exclusion or deduction (by simply multiplying the amount of the exclusion or deduction by the individual’s marginal tax rate).
This distinction is important because misconceptions about the tax benefit of deferral could lead to misguided and harmful policy proposals.
Many analysts apparently don’t understand this difference, and thus fall victim to the trap.
For example, in “Fixing Upside-Down Tax Breaks Should Be a No-Brainer, But…”, Monique Morrissey, a retirement analyst at the Economic Policy Institute, says, “Current tax breaks are very poorly targeted. For the same dollar contribution to a 401(k), high income taxpayers in the 35 percent tax bracket get a tax break that’s three-and-a-half times larger than the tax break received by moderate-income taxpayers in the 10 percent bracket.”
That “Clang!” you hear is the sound of the tax trap claiming another victim.
What Matters Most: Age and Time
In fact, recent ICI research, The Tax Benefits and Revenue Costs of Tax Deferral, finds than individuals’ ages are typically more important than their marginal tax rates in determining how much they benefit from the deferred taxation of compensation contributed to employer-provided retirement plans.
The study shows, for example, that in realistic simulations for a variety of investments, the tax benefits from a one-time $1 contribution to a retirement account are greater for a 45-year-old with a 15 percent marginal tax rate than for a 60-year-old in the 35 percent tax bracket.
For more about the true roles of tax bracket, age, and time in saving for retirement, check out this blog post by ICI Senior Economist Peter Brady.
Why Avoiding This Tax Trap Matters
As policymakers grapple with federal deficits and other long-term challenges, like funding Social Security and Medicare, it’s critical that they understand how 401(k) taxation works. Americans overwhelmingly support the 401(k), and they support the tax incentives that help them to achieve their savings goals. The U.S. retirement system is strong and is working for millions of Americans—but we can and should do more to build on its successes. That includes preserving 401(k) taxation for all savers working to build their nest eggs.
Mike McNamee is chief public communications officer at ICI.
Yes, DC Follies Hurt Retirement Savers—But Let’s Not Overstate
By Brian Reid
October 10, 2013
“Debt ceiling follies” certainly do put retirement savers and their assets at risk. On that, ICI agrees with a recent Washington Post blog.
Revenue Estimates of Restricting Tax Deferral: It Ain’t Necessarily So
By Peter Brady
September 20, 2013
Fifth in a series of posts about retirement plans and the policy proposals surrounding them.
In previous Viewpoints posts, I explained that retirement contributions are neither tax deductions nor tax exclusions, but rather are tax deferrals. I also explained why, in my opinion, the two most prominent proposals to restrict qualified deferred compensation are flawed (post three and post four).
Tax Reforms Should Not Favor DB Plans over DC Plans
By Peter Brady
September 19, 2013
Fourth in a series of posts about retirement plans and the policy proposals surrounding them.
In The Tax Benefits and Revenue Costs of Tax Deferral and in two previous Viewpoints posts (post one and post two), I explained the benefits that workers get from deferring tax on compensation set aside for retirement.
A ‘Modest’ Proposal That Isn’t: Limiting the Up-front Benefits of Retirement Contributions
By Peter Brady
September 18, 2013
Third in a series of posts about retirement plans and the policy proposals surrounding them.
Marginal Tax Rates and the Benefits of Tax Deferral
By Peter Brady
September 17, 2013
Second in a series of posts about retirement plans and the policy proposals surrounding them.
In a previous Viewpoints post, I discussed the difference between tax deferral—the tax treatment applied to retirement savings—and tax deductions and exclusions, such as the mortgage interest deduction or the exclusion of employer-paid health insurance premiums from income. The difference is often overlooked or misunderstood, leading to inaccurate analysis and harmful policy proposals.
Retirement Plan Contributions Are Tax-Deferred—Not Tax-Free
By Peter Brady
September 16, 2013
First in a series of posts about retirement plans and the policy proposals surrounding them.
In today’s fiscal and political climate, taxes are never far from politicians’ minds. Whether to achieve comprehensive tax reform or to raise revenue to meet budget deficits, members of Congress are now considering changes to a range of tax code provisions—including those governing retirement policy. Any comprehensive effort to address fiscal policy or tax reform should examine every option, but some discussions of retirement policy have been misguided. The tax treatment of retirement savings—tax deferral— too often has been lumped together with tax deductions (such as the deduction from income of mortgage interest expense) and tax exclusions (such as the exclusion from income of employer-provided health insurance premiums).