Tax shelter or trap?
- By Milt x_Zall
- Aug 20, 2001
Contributing to 401(k) and similar tax-deferred retirement accounts such
as the government's Thrift Savings Plan (TSP) certainly lowers current taxes.
But does it lower your lifetime taxes?
If everyone paid the same tax rate, the answer would be an unambiguous
yes. But tax rates may be higher when TSP withdrawals occur — either because
you move into a higher marginal federal and state tax bracket, or because
the government raises tax rates.
In addition, lowering your tax bracket when you're young, at the price of
moving into a higher tax bracket when you're older, may reduce the value
of your mortgage deductions. And shifting taxable income from your youth
to your old age can substantially increase the share of your Social Security
benefits subject to federal income taxation.
These ideas come from two researchers at the Federal Reserve Bank of Cleveland
and a professor at Boston University. They wrote in a recent paper that
participating fully in the TSP appears to raise, rather than lower, the
lifetime tax payments of most workers, particularly those with low and moderate
incomes.
Contrary to the prevailing view that feds should contribute as much
as possible to the TSP, the authors say that because of the way the government
taxes Social Security benefits, many feds should consider limiting the money
they stash in tax-deferred programs.
The two researchers found that a couple that earns $50,000 and realizes
a 6 percent return on their investments wound up paying 1.1 percent higher
taxes and suffered a 0.4 percent reduction in spending over their lifetimes
by fully participating in a deferred contribution plan such as the TSP.
By participating in a 401(k) plan or the TSP, middle- and low-income
households found themselves in higher tax brackets once they retired and
had more of their Social Security benefits subject to taxation.
The authors added an important caveat: employer-matching contributions,
such as the government's matching of TSP contributions for employees in
the Federal Employees Retirement System, more than make up for the increase
in the lifetime taxes they computed. But for those in the Civil Service
Retirement System, there is no government match.
Given the uncertainty over future tax rates, this study is certainly
food for thought, but that's about all. The 1.1 percent tax increase is
so minuscule that it's not worth worrying about. And the study didn't take
into account the effects of the recent Bush tax cut.
My advice? If you're in FERS, you should continue contributing to get
the full employers' match. But once you've gotten it, you may want to invest
additional money in a Roth Individual Retirement Account, rather than the
TSP, because Roth IRA withdrawals aren't taxed. If you're in CSRS, the case
for making Roth IRA contributions is even stronger because there is no government
match for your TSP contributions.
Zall is a retired federal employee who since 1987 has written the Bureaucratus
column for Federal Computer Week. He can be reached at [email protected].