What's the benefit of a tax-deferred IRA or 401(k)?

Question

Does the benefit of a tax-deferred investment account (like a regular IRA or 401(k) plan) come entirely from the possibility that I may be in a lower tax bracket in retirement?

I think I understand the mechanics of these accounts: If I take my money and save it in a normal taxable account, I pay tax now at my current tax rate, then I pay tax on the income at my normal tax rate, and I pay tax on the capital gains at the capital gains tax rate, which is normally lower than my tax rate.

If I put my money in a tax-deferred account, I pay no taxes on the contributed amount or the income till I retire; then I pay tax on the full amount withdrawn at my post-retirement tax rate. (And I lose the benefit of the lower capital gains rate.)

If someone's pre- and post-retirement tax rates are the same, is there any benefit to a tax-deferred account?

(The 28% Fed. tax bracket extends from $77K to $160K, so it's not hard for someone to be in the same bracket pre- and post-retirement.)

Answer 1

Many peoples retirement incomes are lower so the deferred is best for them .
For the few that will have equal or higher , the Roth IRA is a better option .

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Answer 2

No, the other benefit to tax-deferral is that you pay the tax later, so you can invest the money that otherwise would have gone to taxes.

For illustrative purposes, let's say your bracket is 28% before and after retirement and ignore state income taxes.

Let's say you earn $2000 (before taxes) more than what you would need to earn to pay your immediate expenses (including all taxes on that lower amount and social security and medicare taxes on the $2000, but not income tax on the $2000).

You can either:
a) Receive the $2000 in your pay, pay $560 in tax on it, and put the remaining $1440 into a regular, non-deferred account.
b) Put the $2000 into a 401K and pay no tax on it or put it into a traditional IRA and deduct it on your 1040.

Let's say that your investment doubles in value.
a) You now have $2880 in the account. Even if all the income is capital gains (no dividends) and you do not sell any shares until the end (to delay capital gains taxes as long as possible), you pay a capital gains tax of 20% (the current 15% rate expires soon) of the $1440 gain, which comes to $288, leaving you with $2592.
b) You have $4000 in the account. When you withdraw the money, you pay $1120 in taxes, leaving you with $2880.

In fact, even if there were no taxes on the normal taxable account, you would still have $2880, the same as you have after tax from the tax-defered account. The amount you save on taxes when you put the money into the 401K or deductible IRA ($560) plus the earnings on it (another $560) comes to enough to pay the $1120 tax on the distribution.

However, all of the advantage relative to a Roth IRA is from the difference between your pre-retirement and post-retirement tax brackets. If you really believe that you will be in the same tax bracket post-retirement, then a Roth IRA is as good as a regular IRA.

Answer 3

No, the benefit comes from both the initial reduction in income taxes for the 401k or IRA and the tax-deferral on growth inside the 401k or IRA.

If you compare the two investments, you have only 72% to invest after taxes compared to your IRA investment. So, compare a $10,000 IRA with a $7,200 investment in stocks.

If your tax rates do not change at all, and you keep both investments the same amount of time, both accounts grow at the same rate, the tax-deferred account is going to give you more money after taxes even though you are going to pay 28% taxes on the retirement account distributions and would pay 15% on the capital gains.

This is true no matter how long you hold the accounts, given your assumptions that you are always taxed at 28% for ordinary income, ignoring everything else.

Answer 4

With the IRA or 401(k), you can either have your taxes reduced now by taking the deduction (IRA) or not having that portion of your income taxed (401). When you withdraw the money, the total withdrawal is treated as ordinary income.

If you get the Roth version of an IRA or 401(k), you will not get the deduction for the contributions. However, you will not pay any income taxes on the withdrawals.

Simply investing the money in a regular investment account, your investments are made with after-tax dollars and your earnings are subject to either income tax or capital gains tax depending on the length of time the investment is made.

Answer 5

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