I regret to inform you that our marketing department has vetoed my suggestions to change the title on my business cards to “Magician.” Do not let that (temporary) setback fool you. The “magic” of tax deferral is very real and something you absolutely want to be working in your favor.
A common concern that I hear from 401(K) participants is why should one bother deferring taxes today if there are going to be taxes as ordinary income in retirement. The major benefit here goes back to the concept of marginal tax rates from last week’s blog. Recall that each dollar earned goes into the tax bucket taxing at that given rate until the bucket is full and flows over into the next, higher, tax rate bucket.
When deferring dollars into a pre-tax account, you are taking those dollars off the top of your income, therefore avoiding your highest marginal tax rate. In retirement when you draw from your retirement account, the dollars are taxed as ordinary income. It is important to remember that again, you need to “fill” each tax bucket before moving on to the next higher tax rate. If you happen to retire and have the exact same gross income as you do while working, you will have deferred all dollars from your top bracket and withdrawn at each tax bracket in retirement.
For example, if your married household brings in $150,000 of gross income your marginal tax rate is 22%. If you deferred $10,000 into a pre-tax 401(K) account, you will have avoided $2,200 of currently due federal income tax.
You continue to do so for your working career. In retirement, you would like to gross $150,000 of income to be drawn from said pre-tax 401(k). When drawing funds out, some of those dollars will be part of your standard or itemized deduction, therefore triggering $0 in federal income tax. Next, some will pay 10% income tax. Followed by 12%. Then eventually landing you in the same tax bracket at while you were working. The key here is that while all dollars saved into the 401(K) avoided 22%, many of those dollars were drawn out at a tax rate significantly lower than 22%.
At today’s tax rates, $150,000 saved from 22% taxes saved you $33,000 of income tax. When drawn in retirement, the tax burden on $150,000 would have resulted in $19,124 of income tax, a $13,876 savings or 9.25%.
While the magic of tax deferral is not as breathtaking as sawing your lovely assistant in half, dramatically reducing your tax liability might be a more practical form of magic we all could benefit from in our daily lives.