Your 401(k) and Taxes: What to Consider Right Now

July 22, 2020

401(k) plans were authorized by the Revenue Act of 1978 and took effect in 1980. Since then, we have seen a major decline in the number of employers offering pensions, making defined contribution plans more important for retirement income. Just how important? According to the Social Security Administration, in about fifteen years from now, the average retiree will be responsible for creating around 66 percent of their own income. 401(k) plans and other defined contribution plans will be a major component of that percentage.

Some people argue that the benefits of a 401(k) plan are not as strong as they once were.  A writer for Bloomberg stated that 401(k) plans no longer make sense for savers. Why would someone say this? This misleading comment is based on the idea that 401(k)s are only a tax shelter and that their advantageous characteristics depend on only four specific factors, all tax based.

The four factors were stated to be:

i.) the marginal federal income rate was 43% in 1980 and is now 12%

ii.) the capital gains rate was 28% and is now 0%, but only for some people and only for a portion of the capital gain

iii.) the likely retirement bracket was 15% in 1980 and is 12% today and,

iv.) interest rates were around 15% in 1980, compared to almost 0% today.

Let’s think for a moment.

401(k) plans are not just about taxes. They are about saving, investing, outpacing inflation, and oftentimes, targeting better rates of return than inflation. They are also about getting an employer match, utilizing the power of tax deferral, having a loan source in times of hardships, creating retirement income, and more. There are quite a few reasons to use defined contribution plans, other than just for tax benefits. However, let’s go ahead and discuss taxes for a moment.

After 2008/2009, we saw the Fed print around four trillion dollars, and we saw the International Monetary Fund issue SDR’s (Special Drawing Rights) at a rate of eight and a half times more than it had in the previous forty years combined. (As a side note: for those unfamiliar with SDRs, when this happens, it is important to take note of just how deeply impacted the money supply truly is for different countries. It is typically not a sign of things going well). We haven’t seen much for inflation in decades. We saw the US dollar come off the gold standard in 1971, which begs the question, what is money truly worth? We have seen suppressed interest rates for over a decade. Now, due to the pandemic we are experiencing, we saw the issuance of $2.2 trillion stimulus package, and we were hearing of the need for more stimulus money before that one hit the streets. Large corporations have taken on, relatively speaking, large amounts of debt due to the favorable interest rate environment, but then asked for help from the government when they didn’t have the cash to support themselves during the pandemic. Some of these companies and many others hold a large amount of debt. If I were to guess, the next crisis will be the debt crisis—think student loans as well.

How will this be rectified? How will it be paid for? A simple answer would be taxes; we have seen it happen before. The current 12% marginal tax bracket is surely favorable, and once it increases, I am not confident I will see it that low again within the next twenty-five years.

Let me ask you a few questions:

Do you think taxes will be higher or lower in the future?

Would you rather pay taxes at 12% or what they will likely be in ten years from now?

If your answer is 12%, you’re probably right.

If you are currently saving in a 401(k) or other defined contribution plan, I suggest you check with your tax professional and determine what your tax bracket is at this time. If it is low, say 12%, you may want to consider making your 401(k) contributions to the Roth portion of the plan. This will allow you to pay taxes now at a potentially lower rate than in the future, have your money grow tax-deferred, and enjoy tax-free withdrawals in retirement when taxes will possibly be higher (depending on when you retire).

Again, the tax bracket in 1980 was 15%. I would not be surprised if it is higher than this in the near future. Interest rates were also around 15% in 1980. Could this happen again? I think it could, easily. The marginal rate was 43% in 1980, which in my opinion is not a far cry from what is possible in the next ten to fifteen years.

The July 21, 2020, Bloomberg article, 401(k) Plans No Longer Make Much Sense for Savers, specifically states, “In 2020, there is no tax advantage remaining to the 401(k).” I could not disagree more. If any of what I previously mentioned happens, or even remotely happens, the tax advantages will remain strong, especially if the Roth component of the plan is utilized now, while we are still in a relatively favorable tax environment. If interest rates change (go-up) and tax brackets do the same, the benefits will still be strong, but the pre-tax contributions will become more favorable once again. In this situation, the person with the Roth money will be patting him or herself on the back.

The bottom line is that you need to play the game; sometimes that requires you to pull the right people onto your team who know how to read the cards and move the pieces.

I have learned that money is currency, like energy, and it doesn’t just disappear, but rather changes forms and hands. There is always an opportunity, but where that opportunity lies is a constantly moving target. When you look for deterrents, that is what you will find; when you ask, “where has opportunity shifted to at this time?” then you begin to look for it and then find it.

I suggest you recognize that opportunity always exists, and it is the job of you and those on your team to find it, even throughout the forever-changing economic and tax landscapes.

All for now,

Jac

Jac M. Arbour CFP®, ChFC®

Jac Arbour is the President of J.M. Arbour Wealth Management and can be reached at 207-248-6767.

Investment advisory services are offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.