401(k)s Can Be A Tax Trap Instead of Tax Shelter

Low & Moderate Income Families May End Up Paying Higher Taxes By Investing Fully in 401(k)s & IRAs

DALLAS (Jan. 31, 2002) — Most people believe that saving in tax-deferred retirement accounts, such as 401(k) plans and traditional IRAs, will reduce their total taxes over their lifetimes. Yet according to a new study by the National Center for Policy Analysis (NCPA), these retirement accounts might actually cause low- and middle-income families to pay more in taxes.

“For those at the upper end of the income scale, 401(k) plans offer a huge tax benefit,” said Laurence Kotlikoff, an economics professor at Boston University and coauthor of the study. “But for most taxpayers, a 401(k) plan may actually be a tax trap.”

  • If a couple earns $50,000 per year at age 25 and makes maximum 401(k) contributions over their work-life, their lifetime taxes will actually go up by more than $1,077 assuming a real rate of return of 6 percent.
  • At an 8 percent real rate of return, lifetime taxes would increase by more than $7,000.
  • If the federal government raises future tax rates – which is very likely given the large unfunded liabilities in Social Security and Medicare – 401(k) participants will do even worse.

In all cases, the family would be better off avoiding the 401(k) deposit, paying taxes on the sum and investing it in a non-tax sheltered account. One reason 401(k) contributions increase the taxpayer’s total taxes is the Social Security benefits tax. Although nominally a tax on benefits, it’s actually a tax on other income.

“The Social Security benefit tax puts many people in a higher tax bracket after they retire than before,” said Kotlikoff. “So instead of paying taxes at the time of their life when they are in a lower tax bracket, 401(k) plans delay the payment until they are in a higher bracket.”

Another problem is that large accumulations in a tax sheltered account mean large payouts during the retirement years and this also pushes seniors into higher tax brackets. “The more 401(k) income a senior has, the higher the tax bracket they are pushed into,” said Kotlikoff.

Ironically, families are more likely to gain from 401(k)s if they contribute, say, half of what is allowed, or they earn a low rate of return, say, by investing in government bonds. If less accumulates in the account, there will be less income and, therefore, a lower tax bracket during retirement.

Large accumulations in IRA accounts can create a similar problem. Consider again the family earning $50,000 a year:

  • If each spouse deposits $2,000 per year into an IRA, the couple’s lifetime taxes will be reduced by more than $6,000, assuming a 6 percent real rate of return.
  • But if the couple takes advantage of the new law and deposits $5,000 per year, beginning in 2008, they will be worse off – paying more than $5,000 in additional taxes, over their lifetime.

By contrast, participating in a Roth IRA is almost always a good deal – regardless of the family’s income level. Roth IRA deposits are made with aftertax dollars, and withdrawals during their retirement years are tax free. “The same couple that loses with a 401(k) plan and a tradition IRA, can enjoy a $6,000 lifetime tax savings if they contribute instead to a Roth IRA,” added Kotlikoff.

Under current law, employers will be able to offer a Roth-type 401(k) account beginning in 2006. However, the law that permits this option will expire at the end of 2010. “Clearly more reform is needed,” said Kotlikoff.