Thursday, March 31, 2011

Higher tax rates will destroy 401k savings...

Higher Tax Rates Loom for 401(k) Savers

Delaying the tax hit on retirement-plan contributions, a much vaunted benefit of 401(k)s, isn't as valuable if you face higher income-tax rates when you retire.

Yet higher tax rates are all too likely in the years ahead.

For years, the standard thinking has been that people drop to a lower tax bracket in retirement. Thus, with a 401(k), you get years of investment returns building on money that otherwise would have gone to taxes, and when your tax bill on 401(k) withdrawals comes due, you pay at a lower rate.

"For the longest time, it seemed like almost a no-brainer that people, when they were in their income-earning stage, would be in a higher tax bracket," said Marcia Wagner, principal of Boston-based Wagner Law Group, a law firm specializing in employee benefits. "That may or may not be true in the future."

While it's difficult, if not impossible, to predict how lawmakers will handle future tax rates, some say a future increase in federal income-tax rates appears inevitable.

"If you look at the federal deficit, I don't see any way the tax rate is going anywhere but up," said Jack VanDerhei, research director with the Employee Benefit Research Institute, a nonprofit research organization.

Smaller accounts less likely to be affected

What does that mean for 401(k) savers? If your nest egg is small, and Social Security will provide the bulk of your retirement income, you're likely to be in a lower tax rate when you retire. It may well be low enough that any changes to federal income-tax rates won't make a big difference to you.

But those with a heftier retirement account — large enough to pay an income not far below what they earned while working — may find themselves in the same tax bracket in retirement. And they may take a hit if lawmakers raise income-tax rates in the interim.

Also a factor: the amount of time you have until retirement. The longer you have, and the smaller the tax increase when you get there, the likelier it is that contributing to a 401(k) will work out to your benefit, VanDerhei said.

That's because your investments have time to grow. "The longer you're in the plan, the smaller the differential between the two [income-tax] rates, and the higher the rate of return, the more likely it is to stay in the favor of the employee to make the contributions," VanDerhei said.

But "if you're too close to retirement and the gap between the tax rates pre- and post-retirement is too large, it [may not] work out to the benefit of the employee," he said.

Another wrinkle: In retirement, distributions from tax-deferred accounts such as a 401(k) become part of your adjusted gross income, said Laurence Kotlikoff, professor of economics at Boston University and founder of, an online retirement-planning tool.

"If you take enough money out in a given year," he said, "it can lead to higher taxes on Social Security benefits."

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