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.
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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 ESPlanner.com, 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."
Don't drop your 401(k)
This isn't to suggest that you forgo your 401(k).
"The 401(k) savings vehicle is ridiculously robust and important to our retirement security, regardless of the tax ramifications," Wagner said. "It makes saving easy."
Others agree. "Even though you might have to pay a higher tax rate when you take out the money, you have earned all of the buildup in the accounts tax-free," said Teresa Ghilarducci, professor of economics and director of the Schwartz Center for Economic Policy Analysis at the New School for Social Research in New York.
Still, she said, higher taxes are one risk among many for 401(k) investors. Bigger risks include stock-market volatility and hidden fees.
And the current economic situation may be among the worst for people set to retire in the next few years, Ghilarducci said. Their account balances haven't yet recovered from the market downturn. Plus, they made pretax contributions when tax rates were generally low. When they're ready to pull out their money, tax rates may rise.
Given the tax-rate outlook, savers should assess ways to diversify their tax situation in retirement. That means at least considering putting a portion of the amount they save for retirement into a Roth individual retirement account — or a Roth 401(k) if one is offered by their employers.
The maximum Roth IRA contribution is $5,000 in 2011 ($6,000 if you're 50 or older), but that amount is reduced for single individuals with modified adjusted gross income of $107,000 ($169,000 for joint filers). And contributions aren't allowed at all for singles with income above $122,000 ($179,000 for couples). (There's no income limit for converting to a Roth from a traditional IRA, however.) For a 401(k) with a Roth option, your contributions are limited to the maximum for the plan over all: $16,500, or $22,000 if you're 50 or older, for 2011.
"If you think taxes are going up, it makes sense to pay your taxes when rates are low, put the aftertax amount into the Roth and take out your money tax-free when tax rates are high," said Alicia Munnell, director of Boston College's Center for Retirement Research and a professor at the school's Carroll School of Management.
Mind the tax hit
Either way, be aware that a tax bill is coming on your 401(k) savings.
"People have forgotten that they're going to owe taxes on this money," Munnell said. "It's really going to be a shock when you pull it out and you find you can only keep two-thirds."
One of Wagner's clients, when his savings reached the $1 million mark, told her that he considered himself rich, and ready for retirement.
Said Wagner: "I said, 'Listen, after taxes, this is essentially half a million bucks.'"