Who’da thunk it? 401(k) plans really do lead to higher taxes

Have you seen these comments here and there? I’ve seen them. I’ve seen them in LinkedIn groups. I’ve seen them occasionally from the folks I interview. I’ve seen them from experienced pros and from well-meaning amateurs. It’s a comment that goes something like this: “The 401(k) tax advantage is a myth.” (You can see some of the comments from industry veterans in “Fact or Fiction? Slaying the Myth of the 401(k) Tax Advantage Myth,” FiduciaryNews.com, Sept. 10, 2013). 

The argument against calling 401(k) plans “tax advantaged” is really quite simple. In the old days, when we had many more tiers to our tax rates and those marginal rates were much higher, saving money in a tax-deferred vehicle made obvious sense. Back then, having experienced two generations of high progressive tax rates and more than a decade of economic stagnation, the world knew it must lower tax rates to “rise the tide that lifted all boats.” It was therefore common sense that tax rates would only go lower. 

Related story: Altering of 401(k) tax incentives alarms retirement industry

Today, that sense is not so common. With only a few tiers and the foreboding success of political campaigns based on class warfare, the tax advantages of saving in a 401(k) plan have slipped the surly bonds of earthly economics. There’s a growing consensus now that we’ll be lucky if our tax rates remain the same when we retire. Many fear they’ll be higher. 

Again, many do the simple math in their head and conclude, if the tax rates remain the same, the tax “advantage” evaporates and any current tax savings is erased in the future when we cash in our 401(k). And, so the logic goes, if the best we can do is break even, why play the game at all. 

Except it’s not true. 

Well, some of it is, but the important part isn’t. 

It’s not too hard to test the hypothesis that investing in a 401(k) is a tax wash if tax rates remain the same. You just create a spreadsheet mimicking monthly payments (and relevant tax withholding) and compare the total taxes you pay in an after-tax scenario versus the total taxes you pay in a pre-tax scenario. For even greater fun (have you by now detected how boring my life is?) you can compare the after-tax value of the remaining investments in both scenarios. 

Of course I did this. Here’s what I found out. 

You pay more taxes in the pre-tax 401(k) savings scenario than in the after-tax savings scenario. In fact, the longer you save in a 401(k), the more extra taxes you’ll pay. For example, you’ll pay about 3.5 times more if you save in a 401(k) for 20 years versus 10 years. If you save for 30 years, you’ll more than 17 times more taxes compared to what you’d pay when saving for 10 years. These figures assume a 15 percent tax bracket for both income and capital gains, saving $100 (gross) per month and growth of 8 percent. 

Of course, if you reduce your growth rate, your overpayment of taxes diminishes until you get down to 0 percent (i.e., “no”) growth. At that point, it really is a wash. Only if you have negative returns do you pay less in taxes.

See also: Have 401(k)s failed investors?