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Evaluating Retirement Strategies: What If Income Tax Rates Go Up? (Part 1)

In any discussion regarding the financial issues that face the American government, one of the default responses is finding ways to increase income tax revenues. While some economists may postulate the counter-intuitive idea that lower tax rates often result in higher revenues (and there is some historical support for this perspective), the straightforward approach typically favored by legislators is to increase tax rates and/or eliminate deductions. In 2013 we have seen some income tax increases, and the challenge of resolving the accelerating trajectory of the federal debt makes additional proposals for income tax increases a near certainty.

Given the increasing possibility of higher marginal tax rates, how should individuals evaluate their future participation in qualified retirement plans? Is it better to make pre-tax 401(k) deposits today, and pay taxes on the distributions when the money is used for retirement? Or does it make sense to use a Roth 401(k) and incur the tax cost now–even with higher tax rates–knowing future distributions will be tax-free?

In any tax environment, answering the question of “taxing the seed or the harvest” is a critical decision point. However, a purely financial answer to this question hinges on unknowable future conditions: What will tax rates be at retirement? If tax rates are static, there is no advantage to pre-tax or after-tax qualified retirement plans. This means individual savers must either resolve the pre-tax/after-tax question by guessing their future tax rates, or by using different criteria to make their decision.

The Changing Landscape of Retirement Plans

Twenty years ago, the pre-tax/after-tax discussion didn’t exist because all qualified retirement plans were configured in pre-tax formats: Deposits, up to specified limits, were exempt from immediate taxation and allowed to accumulate tax-free. At distribution (typically after age 59?), any withdrawals would be taxed as regular income. The logic for pre-tax saving was simple: Because it was assumed one’s retirement income would be less than when working, distributions would be taxed at a lower rate.

The granddaddy of pre-tax retirement plans was the Individual Retirement Account (IRA), authorized by Congress in the mid-1970s. As the popularity of this format spread, it spawned other variations, including the 401(k), which is today the prevalent employer-sponsored qualified retirement plan.

However, the three decades since the advent of pre-tax retirement saving have shown that the assumption of lower taxes in retirement may be invalid. First, tax changes in the 1980s “flattened” marginal tax rates; the number of tax brackets between “high” and “medium” income levels were reduced, making it less likely that a decrease in income at retirement would result in a lower tax rate. Second, the lifestyle patterns of successful savers often meant that tax deductions taken during their working years (for dependents, mortgage interest, etc.) were no longer available in retirement; the house was paid for, and the kids had moved out. A flatter tax structure, and the absence of deductions, combined with substantial accumulations, frequently results in a higher tax paid on distributions compared to the savings on the pre-tax deposits.

Recognizing that this higher-tax-in-retirement scenario might discourage retirement saving, Congress established Roth IRA accounts in 1998. In the Roth format, deposits are made with after-tax dollars, and, similar to IRAs, allowed to accumulate tax-free. The big difference: distributions are free from income tax as long as the funds have been in the account for five years and the account holder is over 59?. In 2001, additional legislation expanded the Roth format to permit employer-sponsored plans, beginning in 2006.

Today, it is possible for employers to offer both pre-tax 401(k)–and after-tax–Roth 401(k) retirement accumulation plans. Although some features are dependent on the provisions elected by the employer, employees can contribute to both types of plans in the same year, provided total contributions don’t exceed the annual threshold ($17,500 in 2014). Additional changes in 2010 expanded 401(k)/Roth 401(k) options to include conversions of existing pre-tax 401(k) balances to Roth 401(k) status by paying the tax now. The American Taxpayer Relief Act of 2012 (ATRA) also further expanded options to convert.

The February 9, 2013, Wall Street Journal (“More Firms Roll Out Roths”) reported that only half of employers currently offer Roth 401(k) options alongside their regular 401(k)s. However, more than one-fourth of those 401(k)-only companies were planning to introduce Roth 401(k) options in the coming year. As a result of these changes, many individuals will be facing two questions:

1. Going forward, how should I save for retirement–pre-tax or after-tax?

2. Should I convert my pre-tax savings to after-tax status?

It should be noted that 401(k)-to-Roth 401(k) conversions are subject to some precise terms and conditions and may result in significant tax consequences. But whether the question is new deposits or re-characterizing existing accounts, the issue remains the same: pay tax on the seed or the harvest?

Elozor Preil, RICP®, CLTC is Managing Director at Wealth Advisory Group and Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). He can be reached at [email protected]. See www.wagroupllc.com/epreil for full disclosures and disclaimers. Guardian, its subsidiaries, agents or employees do not give tax or legal advice. You should consult your tax or legal advisor regarding your individual situation.

By Elozor M. Preil

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