Taxable or Tax-Deferred?

Let me tell you how it will be
There's one for you
Nineteen for me
--The Beatles

Since the advent of individual retirement accounts (IRA) and 401(k) employer-sponsored retirement plans over 30 years ago, financial planners have been promoting these 'tax-deferred' investment accounts as the primary vehicles for accumulating retirement resources.

Tax-deferred accounts do have benefits. Each year, individuals can contribute funds, up to a limit, to an IRA or 401(k) 'before tax,' meaning that contributions are subtracted from your paycheck before income taxes are calculated. Moreover, gains from capital appreciation and dividends that accumulate in these accounts are tax-deferred, meaning that account holders do not pay taxes on these gains until withdrawals are made--presumably far down the road during retirement. An additional benefit of 401(k)s is that employers often match a percentage of employee contributions up to a particular limit, offering what essentially amounts to a salary bump for participating employees.

Tax-deferred accounts do carry disadvantages, however. Tax-deferred does not mean tax-free. When individuals do withdraw from IRAs and 401(k)s--and they are legally required to begin doing so by age 70 1/2 if they have not done so sooner. Those distributions are then subject to ordinary income tax. While it is often assumed that individuals will be in lower income tax brackets by the time they retire, the reality is that future tax rates are uncertain, and an argument can be made that future tax rates could be considerably higher depending on the political climate. For instance, higher tax rates might be deemed necessary down the road to fund our burgeoning and ever-increasing federal debt.

One way to reduce this risk is to open what is known as a Roth IRA. Contributions to Roth IRAs are done 'after-tax.' meaning that you pay income taxes upfront on your contributions. Because you've paid taxes on the front end, withdrawals subsequently made during retirement are not subject to further taxes. For many people already involved in saving for retirement using the above-mentioned tax-deferred vehicles, however, Roth IRAs tend to be viewed as more of a supplemental vehicle for wealth-building. Roth IRAs are also subject to future political risk that could reduce or even eliminate the tax benefit.

Perhaps the largest disadvantage associated with tax-deferred accounts is loss of financial flexibility. Once you contribute to an IRA or 401(k), you lose access to those funds for a long period of time. If you want to withdraw from a tax-deferred account before you are legally permitted to do so, then you must pay a substantial penalty. Early withdrawals from a 401(k), for instance, are commonly subject to a 10% penalty in addition to the income tax burden.

The commitment that accompanies tax-deferred investing creates a strange (and risky) situation. Conceivably, you could be socking away lots of excess income in IRAs and 401(k)s yet have insufficient savings available to fund life in the present. By tying up economic resources in tax-deferred vehicles, you can compromise capacity for living in the here-and-now. Your financial flexibility declines.

Can you see that one explanation for rising household debt loads over the past few decades is the diversion of too much income toward IRAs and 401(k)s--which has left these people with insufficient  savings for funding everyday expenses? Borrowing has been necessary to make ends meet.

So how did people save for retirement prior to IRAs and 401(k)s? Some employers offered 'pension' plans that promised employees a pre-determined monthly retirement income based on years of service. Most of these 'defined-benefit' plans are being phased out in favor of the 401(k) 'defined-contribution' design. Of course, not everyone worked for employers with rich pension plans. How did they save?

They simply used taxable vehicles. For everyday savings they kept money in checking and savings accounts. Lots of money. High balances in these accounts allowed funding everyday expenses while still saving for the future. For people seeking more potential return on their capital, then they could open taxable brokerage accounts to enable purchase of stocks, bonds, and other risky assets.

Use of taxable saving and investment vehicles permitted previous generations to remain financially flexible. They could comfortably provide for the present while saving for the future in a direct, uncomplicated manner.

Today's focus on IRAs and 401(k)s has reduced awareness of the benefits from taxable saving and investing. In a future post, we'll discuss advantages of taxable brokerage accounts in more detail.