SmartMoney Blogs

A blog about living in and planning for retirement

What’s the Tax Advantage of 401(k)s?


Alicia Munnell, the director of the Center for Retirement Research at Boston College, is a weekly contributor to “Encore.”

Tax reform is high on the nation’s agenda. While Republicans and Democrats may disagree about the extent to which tax increases should be part of the deficit reduction effort, they generally agree that a broader base and lower rates for the federal income tax would promote fairness and boost economic growth. The base-broadening discussion inevitably raises the question of cutting back on some “tax expenditures.” These expenditures are revenue losses attributable to provisions of the tax laws that are designed to support particular activities. A prime example is the provisions that encourage retirement savings. It seems like a good time to understand the nature of these expenditures, determine how the revenue losses are calculated, think about how tax reform could affect the value of these provisions, and speculate how changes might affect participation and contributions in tax-advantaged savings vehicles, particularly 401(k) plans.

The Conventional 401(k)

Retirement saving conducted through 401(k) plans is tax advantaged because the government taxes neither the original contributions nor the investment returns on those contributions until they are withdrawn as benefits at retirement. If the saving were done outside a plan, the individual would first be required to pay tax on his earnings and then on the returns from the portion of those earnings invested. Deferring taxes on the original contribution and on the investment earnings is equivalent to receiving an interest-free loan from the Treasury for the amount of taxes due, allowing the individual to accumulate returns on money that he would otherwise have paid to the government.

The Roth 401(k)

Since 2006, employers have had the option of offering a Roth 401(k). Under this arrangement, initial contributions are not deductible.  But investment earnings accrue tax free and no tax is paid when the money is withdrawn. This arrangement is superior to saving outside a plan because no taxes are ever paid on the returns to investments.

Conventional and Roth 401(k)s Offer Virtually Identical Tax Benefits

Although the conventional and Roth 401(k)s may sound quite different, in fact they offer virtually identical tax benefits.  Unfortunately, the easiest way to demonstrate this point is with equations.  Assume that t is the individual’s marginal tax rate and r is the annual return on the assets in the 401(k).   If an individual contributes $1,000 to a conventional 401(k), then after n years, the 401(k) would have grown to $1,000(1+r)n.  When the individual withdraws the accumulated funds, both the original contribution and the accumulated earnings are taxable. Thus, the after tax value of the 401(k) in retirement is (1-t) $1,000(1+r)n.

Now consider a Roth 401(k).  The individual pays tax on the original contribution, so he puts (1-t)$1000 into the account. (Note the original contribution in this case is smaller than for the conventional 401(k).) After n years, these after-tax proceeds would have grown to (1+r)n (1-t) $1,000.  Since the proceeds are not subject to any further tax, the after-tax amounts under the Roth and conventional plans are identical:

Conventional                     Roth

(1-t) $1,000 (1+r)n =   (1+r)n (1-t) $1,000

Of course, the preceding exercise assumes that the tax rate that people face in retirement is the same as that when they are young. If their tax rates decline after retirement when they withdraw the funds, then they will pay less tax and have more after-tax income with the conventional 401(k) than with the Roth. If tax rates rise in the future to cover the deficits in the budget forecasts, then today’s workers will face higher taxes in retirement and will have more after-tax income with a Roth 401(k) plan than with a conventional one. But for most people, changes in tax rates before and after retirement are not that significant, so the tax treatment of the two types of 401(k) plans can be viewed as identical.


We welcome thoughtful comments from readers. Please comply with our guidelines. Our blogs do not require the use of your real name.

Comments (5 of 16)

View all Comments »
    • I don’t know if you can roll the Roth into a traditional IRA, but you don’t have to and don’t what to. You do need a sepatare account for your traditional IRA. There is actually no limit on the number of IRA accounts you can own. The annual contribution limit applies to your total contributions to all accounts, but can be divided amount as many accounts as you like. zygote222 is mistaken about traditional to Roth conversions. You pay taxes on the entire amount for such transfers.

    • Yes, you need to open new Traditional IRA account if do not have one now or just use the extnsiig Traditional IRA account. Then just transfer (rollover) that money from Roth IRA to this Traditional IRA for SAME YEAR!Normally you have two choices in your case:1. Either rollover money to Traditional IRA for same yearOR2. Withdraw money from Roth IRA before the due date of income tax return for that year. In other words, you can treat your case as excess contributionto Roth IRA. Also note that you have to any of this action before the due date of income tax return to avoid penalty. Read here for info:. theusefulinfo. com/finance/2007/04/what-if-you-contribute-too-much-or. htmlAnd just to add bonus info, you may be able to convert thismoney from Traditional IRA to Roth IRA in 2010! How? Then read this:. theusefulinfo. com/finance/2007/04/not-eligible-for-roth-ira-high-income. html-InfomanNot a legal advice.

    • Joe’s comment is absolutely correct ! The best someone would do (and this is unlikely) is invest the upfront tax benefit in a taxable account. In this case the backend tax rate must be much lower to just breakeven. Example: $1,000 invested for 30 years, constant tax rates of 28% and constant investment returns of 5%: After 30 years the Roth would be worth $4,322 and the traditional IRA plus the taxable tax benefit account would be worth $3,921 or $401 less. The tax rate on withdrawals from the traditional account must be reduced from 28% to 18.72% just to breakeven. Although I understand you are writing the article from an academic perspective the value of your conclusions get diluted when your assumptions do not match the practical reality of how the world functions.
      P.S. Comment on a relevant related topic. (i.e. convert your taxable IRA to a Roth IRA in 2012 before tax rates increase in 2013 with the expiration of the Bush tax cuts) This strategy is based on only one assumption that tax rates in the future will be higher than 2012′s tax rates. Unfortunately most people are forgetting a significant second variable to the decision. (i.e. the future investment yield on your portfolio) There is no value to the tax shelter that a “tax free” vehicle gives if there is no investment income or conversely there is no economic penalty arising from future higher tax rates if there is no investment income. Thus, even if you assume higher future tax rates, it still might not make economic sense to convert to a Roth in 2012. Example: Upfront tax rate of 32.313% and backend tax rate of 39.834% – time duration after conversion equals 30 years. If future pre-tax investment yield is 1.75% then the post tax IRR is 2.55% versus if the future pre-tax investment yield is 6.00% then the post-tax IRR increases to 6.98%. The investment is the taxes paid to convert and the return on investment is the taxes saved in the future because of the Roth conversion. Thus for a conservative investor the conversion may make no economic sense nor may it make sense for a person invested in the stock market depending on their future investment returns. Example: The S&P 500 as of March 14, 2012 still stands 5.1% lower than where it was at December 31, 1999. Thus,excluding dividends, there has been a negative investment return for over 11 years in the S&P 500.

    • Also assumes one will make the same withdrawal every year. I anticipate making much larger withdrawals in some years- to pay for college, health problems, moving to a retirement home, paying for a wedding. Assuming a similar tax rate structure, your rate may vary widely. I think everyone should have BOTH a traditional and a Roth to minimize whatever taxes we’ll be paying at retirement.

About Encore

  • Encore examines the changing nature of retirement, from new rules and guidelines for financial security to the shifting identities and priorities of today’s retirees. The blog also explores news that affects retirement, from the Wall Street Journal Digital Network and around the web. Lead bloggers are reporter Catey Hill and senior editor Jeremy Olshan. Other contributors include The Wall Street Journal’s retirement columnists Glenn Ruffenach and Anne Tergesen; the Director for the Center for Retirement Research at Boston College, Alicia Munnell; and the Director of Research for Pinnacle Advisory Group, Michael Kitces, CFP.