Is tax deferred saving a bad idea?

The concept is appealing. Save money using pre-tax dollars in a special account. You can use the tax savings to put more money to work. The earnings in the account will not be taxed, and you will have bigger balance years from now than if you had saved after tax dollars in a taxable account. You will pay taxes on your withdrawals, but you may be subject to lower tax rates. You will be much better off than if you save after tax dollars in a taxable account. It sounds too good to be true.

I cannot tell you whether tax deferred accounts make sense for you. That decision should be based on your particular situation. However, before you automatically assume that it is a good idea to put money into tax deferred plan such as an IRA, SEP, 401(k), 403(b), or 457 plan, it makes sense to examine three basic assumptions.

Tax savings means a bigger balance
This may is true. However the tradeoff is that withdrawals will be taxable. Whether deferring tax will give you more after tax income is dependent on current and future tax rates. The biggest reason that balances are larger is that if a person was going to save $100, then he or she would have to earn $139 at a 28 percent tax rate to have $100 to save. The assumption is that people who would save $100 after tax dollars will save $139 pretax dollars. That assumption is not always true.

Tax deferred plans reduce your tax
This may also be true; however the statement is based on several assumptions. If the assumptions are false, which is possible, then tax deferred plans may not reduce your tax bill. They may even increase it. The blanket statement that tax deferred plans will reduce tax burdens is based on an assumption that tax rates will be lower when funds are withdrawn than when the income is deferred. There are several reasons that this might not be true.

One reason is that lifetime earnings follow a predictable pattern. People at the beginning of their careers tend to make less than people later in their careers. A healthy portion of the balance from a tax deferred savings plan is likely to have been set aside when income was relatively low. With progressive tax rates, lower income taxpayers pay tax at lower marginal rates. Of course the argument is that the money will be withdrawn at retirement and income will be necessarily lower. That argument is contrary to the reasons that people save for retirement. The income withdrawn from tax deferred plans will be taxable. If the taxable income is lower, then the plan did not accomplish the objective of accumulating a large enough balance to provide a replacement income.

Another reason that tax deferred plans may not reduce your tax is actually a collection of reasons under one heading: Tax is too complex a subject to make blanket assumptions. Here are just a few of the issues:

• Future tax rates are unpredictable.
• Social Security taxation is tied to other taxable income.
• AMT is usually difficult to plan around.
• If you experience a windfall, then you are likely to have higher income later, and that may mean higher tax rates.
• If you save a lot, then you may have higher income later.
• You may be living in a state with an income tax and plan to retire to a state without an income tax.
• Tax deferred account earnings are taxed as ordinary income at withdrawal. This is true even if the earnings are the result of long-term capital gains or qualified dividends which may be taxed at lower rates.
• Tax rate comparisons assume that alternative investments are taxable investments. This ignores tax-free investments. 

A question of control
In addition to the two assumptions explored above, there is also the question of control. The implicit assumption whenever a person uses a tax deferred vehicle is that he or she remains in control of the investment. This is true even though nearly all people know about age limits for penalty free withdrawals. The withdrawal limitations are a reasonable tradeoff for the tax deferral.

Control of funds in tax deferred accounts is actually a much bigger question than withdrawal limitations. There are two. The first is related to age. Tax deferred plans typically have some sort of required minimum distribution. This means that you will be required to withdraw some portion of your account regardless of your need for funds, and you will be required to pay income tax on the amount you withdraw. This is a huge amount of control to cede in exchange for tax deferral, and it is much more significant than having to reach a minimum age.

The second control question relates to how tax deferred accounts fit into your estate planning. This is a complex topic well beyond the scope of this article. However, the time to find out that tax deferred accounts may not be the best instruments for your estate plan is before you start putting a lot of money into them.

Is tax deferred saving a bad idea?
The answer to this question is dependent on a variety of factors. Tax deferred plans are neither good nor bad. Instead, they are tools that work well in some situations and not so well in other situations. If you are contemplating a tax deferred plan, ask yourself some question such as these:

• What do you anticipate your income will be over your lifetime?
• When do you expect to earn more or earn less?
• What are your expectations about your future tax rates?
• What does your expectation about your earnings and tax rates mean to you?
• How important is it to you to be able to control your withdrawals in the future?
• Do you have estate planning concerns? 

What should you do?

 The first thing you should do is to consider your situation. Ask yourself what you are trying to accomplish. If your objective is to shift income and defer tax, then use a tax deferred plan. If your objective is simply to save for some purpose, explore all of your alternatives and weigh the pros and cons of each. If a tax deferred plan is your best option, the use it. You may find that investing after tax income in a taxable account is your best option. It is likely that you will determine that you need some combination of tax deferred and taxable accounts.

If you are not sure what to do, seek advice from a professional. A CPA or financial planner should be able to explain your options and help you decide. If you have estate planning questions, then be certain that you seek advice from an attorney skilled in that area. If your situation is complex, you may want to involve several advisors with different skill sets.