Government, Investing, Personal Finance 

Beware of Tax Deferred Accounts

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I, and many others, love the Roth IRA because your gains grow tax free. While the government could always change the rules and suddenly decide to tax your earnings, it’s very unlikely because the backlash would be murderous on a political career. With tax-deferred accounts, however, such as the ubiquitous 401(k), there is no guarantee that your marginal tax rate when you’re retirement eligible will be lower than it is now. If it’s higher, you really have no excuse, you knew the rules. Honestly, as a twenty-five year old, I believe the marginal tax rate will be much higher when I retire even if my income goes down. Here’s why…

1. The National Debt
It’s currently a “little” over 8 TRILLION DOLLARS. How have we been able to sustain such an enormous debt? Because countries like China and Japan are willing to buy our Treasury Bonds at the piddly interest rates. There will come a time when the United State will have to become very serious about paying back this debt and when that happens the money will come from one place – taxes. And where do the taxes come from? You, me, and the next poor schmoe.

2. National Health Care
Nearly every major economic power in the world has some form of nationalized health care, funded by taxpayers. It has been shown that the actual % of GDP spent on health care is lower in places with nationalized health care than in the United States and some have a longer lifespan, a nice side effect. In order to pay for nationalized health care, the money will come from taxes, and I believe it’s only a matter of time before the US implements it.

3. Social Security IOU’s
The government’s been spending and spending and it’s been sending IOU’s to cover the balance of the Social Security “lock-box.” Well, with the aging population will start needing their social security checks… the money to pay for the IOU’s will have to come from somewhere, the most obvious place would be with taxes.

I’m not a public policy expert or anything, I’m just a regular old schmo trying to decide whether I should max out my 401(k) contribution or just put in enough to get the maximum matching from my employer. I honestly believe that the tax rate will increase in the future, regardless of how much I plan to make (as if I could even plan 40 years into the future, let along 2). Anyone else have any thoughts on the matter?

401(k), Retirement, Social Security, National Debt

{ 13 comments, please add your thoughts now! }

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13 Responses to “Beware of Tax Deferred Accounts”

  1. Brian says:

    You make a very good argument and I agree that there is the possibility that income tax rates could increase in the future. But I would also offer the counter argument that the government could migrate more toward a national sales tax system in which those with Roths would be hurt. I’m a firm believer that one should be diversified with their tax-advantaged accounts as well as in their holdings. We’ll hedge our bets by maxing out both our 401k and Roth IRA.

    Excellent post; keep up the great work!

  2. Caitlin says:

    I’ve been maxing out my 401k for several years (my one financial consistency) but I am beginning to think i should re-think maxing it until I have a solid cash emergency cushion. As of this year, I am a Roth believer so I am committed to maxing that out for sure. My taxes just feel so darn high (I know…everyone’s hear bleeds for me LOL) that to give up $15k and only get $11k back next year seems…painful. I guess I will end up with something balanced, full Roth, a little “k” and hopefully an emergency fund once and for all.

  3. Jeff says:

    I was wondering … does contributing to a 401k or 403b decrease your Adjusted Gross Income? Between my wife and I, our salaries are going to be too high next year to continue contributing to a Roth IRA … but if the 401k/403b DOES decrease it … that would be one possible benefit?

  4. jim says:

    401(k) contributions does decrease your AGI. I wasn’t arguing that 401(k) or tax-deferred plans were bad, I was just introducing the idea that you might not necessarily be paying lower taxes in retirement – something a lot of people (including myself for a while) assume.

  5. David S says:

    I like the 401(k) regardless of tax b/c

    1) Matching. That’s free money that if you don’t take disappears.

    2) It’s forced savings. If I forgo the 401(k) and put it in the bank or a brokerage, there is always the temptation to spend it. In the 401(k), it’s there till retirement, unless I take a substantial penalty, which I’m not willing to do.

    Also, even if marginal rates go up, your income during retirement may be less than your income now, so it still may be taxed at a lower rate.

  6. Matt says:

    IMHO, the purpose of retirement savings is for _retirement_. If I’m still working at 65 (and I certainly don’t rule that out, nor do I consider it an especially undesirable prospect) and thus still worried about my marginal tax rate, I simply won’t withdraw the money.

    I also think it’s a pretty bad bet to assume that marginal tax rates won’t skyrocket in coming years. But that doesn’t necessarily make maxing out a deferred-taxation plan a bad move.

  7. Guest says:

    I have something to say from a slightly different angle. We have witnessed for the past 100 years and ever increasing growth and valuation of the US Equities market (this is where most 401ks get invested) and the assumption has always been that it will continue to grow. Everyone accepts that there will be a few hiccups here and there but overall the US Equities market will always go up.

    My personal view is that this will NOT be the case over the next 30 – 40 years and here’s why:

    1. 60 to 80 million baby boomers will begin to retire. What are they going to retire on? Social Security and their 401k savings. Beginning in 2008, these retirees will begin to pull money out and spend it to live – they will likely spend most of it on healthcare related expenses.
    We have NEVER had a situation in our country where 1/3 of the population is not working and not putting money into 401ks and the stock market. This will impact productivity tremendously.

    2. Because 60 to 80 million will be retiring, this will deplete the number or workers in the system. This means either those people pay higher taxes and social security contributions and have LESS money for retirement 401k contributions. Granted, these people may ultimately end up earning more because of the scarcity of labor but I don’t think it will be offset enough. A potential negative effect is really high inflation.

    3. Immigration. In order to sustain the system, the country will need millions of new immigrants to help pay for the social services “promised” to those baby boomers as well as more people contributing to 401k. There is a two fold problem here:
    1. Businesses have thrived and wanted cheap labor so the vast majority of immigrants into this country have been typically uneducated manual labor people. This is of no real benefit since most don’t pay social security tax (illegal) or if they do (legal) have hardly enough money to be making 401k contributions into the Equity markets.
    2. Global competition for “high end” labor is taking place. Counties all over the world are cherry picking the best minds out there and competing to get them to immigrate to thier counties. There will be even more pressure to immigrate elsewhere, thus depleting further the labor pool in the US. Keep in mind that most US companies now make more money from their overseas operations than their local US operations.

    So what I’m trying to say is that I have great doubts about the US Equity market long term. Most 401k plans offer limited options as to where your money is invested: A few mutual funds, a few bond funds and some type of cash account. I have conciously made a decision to lower my 401k contributions (from their max) to the minimum matching max and am investing the extra cash in non-equity investments.

  8. King Asa says:

    I thought the point of the 401k being tax deferred is what David S said…

    “Also, even if marginal rates go up, your income during retirement may be less than your income now, so it still may be taxed at a lower rate.”

    Even if tax rates go up, your income level will be less.

  9. jim says:

    If you’re putting money into a 401(k) and you’re in the 10% marginal tax bracket and the brackets are readjusted to where the lowest is 15%, your deferment results in higher taxes in the future.

    It’s an extreme but it’s possible…

  10. Brian says:

    Guest, this is probably beyond the scope of this topic, but here are some things to ponder…sorry I can’t elaborate more – I have to get back to work 🙂

    First, I would say the definition of retirement has changed. For many it means the financial independence to do whatever is desired at any time. There are many who will continue to work because they enjoy what they do. There will be many who will change careers because they want to try something new. Retired or not, smart investors will continue to invest in the stock market with allocations dependent on each individual’s goals NOT their age.

    Second, you stated “that most US companies now make more money from their overseas operations than their local US operations”. If that is the case wouldn’t it stand true that there would be continued growth in US equities because of the continued expansion into these additional markets?

    And finally, you will have a very hard time building enough money to comfortably retire on if you’re sticking the majority of your money in non-equities. Inflation will be a major drag on your savings over time.

  11. Guest says:

    With regards to your second point. The answer is yes UNTIL those countries become their own independent producers and sustain their own economies. The two that quickly come to mind are China and India. China’s government plan is to eventually control their own economy through their own standards. A couple of examples – China is developing their own DVD standard EDVD. Their main reason is that they don’t want to pay royalties to others. China also counterfits just about every american product out there, at some point just cut out the middle man (the US) and sell direct to their population. Warren Buffet wrote a great piece about that here:

    and to your third point, there have been many millionaires and billionaires made without involving equities. Donald Trump (Real Estate), George Soros (Currencies), Bill Gates (Entrepreneur). Millions are there if you are creative enough.

  12. Jim Robinson says:

    Yes, you have a good point, Jim. One of the things I’m finding really annoying are all the limits on contributions to retirement accounts. There are income caps on the Roth IRA, meaning that somebody can do a conversion from a Traditional IRA and then, 4 years later (after they have made the final tax payment on the conversion), they can find themselves at the income-cap limit. This means they won’t be allowed to make any contribution to the Roth IRA, period.

    These caps force people to put money in either the 401(k)/403(b), or into a Traditional IRA. One hopes that the introduction of the Roth 401(k)/403(b) will actually take off ( Another problem with the Roth IRA is the very low maximum contribution limit per year. I don’t think it is unreasonable to assume that a person starting out will need to set aside 25% of their gross income each year for retirement, meaning one hits the contribution limits for IRAs.

    Finally, even though we will probably get the short end w/re to taxes, keep in mind that the tax-deferred growth of your savings might be much higher than would be possible in direct, non tax-sheltered, investments. That shelter can make a big difference, especially with the expectation that stock returns will be lower in the next few decades than they have been in the previous few.

  13. Chiquita says:

    I would like to know if I contribute the maximum ($15k) to my 403b retirement fund will that decrease the amount of taxes I will have to pay for next year? This year is the first year that I have ever owed on my taxes and I am trying to find a way without putting all my money in federal withholding to not owe!

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