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How to Calculate 401(k) Tax Expenditures


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

As noted in last week’s blog post, contributions to 401(k) plans are treated favorably under the federal personal income tax. The government does not tax either the employee or employer contributions to these plans or the investment earnings on the contributions until the monies are withdrawn in retirement. In addition, deferral shifts income to a time of life when people have less income and thereby face a lower tax rate. This treatment significantly reduces the lifetime income taxes of those employees with 401(k)s and costs the Treasury money. The question is how much?

The calculation involves comparing the present discounted value of taxes collected from saving within a 401(k) plan to how much would have been collected if the saving were done outside. Several pieces of information are needed: the amount contributed to 401(k)s, the rate of return earned on investments, the rate used to discount future values to the present, the length of time the money is held in the 401(k), and the average marginal tax rate before and after retirement.

Assume that the rate of return equals the discount rate and that, for the moment, all income is taxed at the same rate. If contributions to 401(k)-type plans – hereafter referred to simply as 401(k) plans – are $280 billion, contributors are age 45, the money is withdrawn at 75, the nominal rate of return is 6%, and the average marginal tax rate is 25%, the tax expenditure for 2010 would be $73 billion.

This initial estimate is too high, because the value of tax preferences for 401(k) plans depends on the tax treatment of investments outside the 401(k) plan. In fact, the maximum rate on realized capital gains and dividends is 15%. The following exercise assumes that the one-third of 401(k) assets held in bonds is taxed at 25% and the majority of the two thirds held in equities is taxed annually at 15% (the remaining portion is taxed only once at withdrawal at age 75 at 15%).

As shown in the Table 1 below, the fact that realized capital gains and dividends are subject to lower rates reduces the value of the tax expenditure. Assuming a 6-percent return and contributors are age 45, the tax expenditure falls to $49 billion.

Table 1. Tax Expenditures for 401(k) Plans* in Billions, Assuming the Same Marginal Tax Rate Before and After Retirement

Rate of return and discount rate Age of contributors
35 40 45 50
4% 45 41 36 31
6% 60 55 49 43
8% 72 66 59 52

*Estimates also include other defined contribution plans.

One more factor needs to be taken into account – namely, for a given tax structure, taxpayers may face a lower marginal rate in retirement than when working. Assuming the average marginal rate for 401(k) participants drops from 25% to 20%, the tax expenditures for different contributor ages and rates of return are shown in Table 2.

Table 2. Tax Expenditures for 401(k) Plans* in Billions, Assuming the Lower Marginal Tax Rate After Retirement

Rate of return and discount rate Average age of contributors
35 40 45 50
4% 58 54 49 44
6% 73 67 62 55
8% 85 79 72 64

*Estimates also include other defined contribution plans.

One could argue that tax rates are going to have to increase in the future so taxpayers may not see lower rates once they stop working; in this case, focusing simply on the value of deferral reported in Table 1 may be more reasonable. But if lower rates are included in the calculation, the tax expenditure in the case where contributors are age 45 and the rate of return and discount rate are 6% was about $62 billion in 2010.


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Comments (5 of 6)

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    • Yup, you are right Google is the most excellent in support of blogging, Googleis blog as well come fast in search engines too.

    • I just lost 5 minutes of my life and I can’t get it back… What is the point of this article? The tax insensitive for retirement saving in an effort of government to motivate public behavior for the purpose of the public good 1.)increase savings therefore increase investment capital in the USA. 2.) Improve the chances of reducing the number of retirees that retire into poverty. 3.) Pander to the Banking, Broker Dealer and Investment Advisers lobbying efforts.

    • It is simply wrong to think of income that isn’t taxed as an “expenditure” by the Government. That sounds like you think the Government is entitled to everything we earn except that which it chooses to let us keep.

    • I have a headache!

    • Saving for retirement without a gov’t hand controlling?
      Fiscal responsibility? The gov’t has none.

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.