Contributing your $3,000 to a 401(k) or other qualified plan, you have the whole amount to invest and investment earnings are tax free – but you have to pay tax when you withdraw it. Leaving it in for, say, 20 years you would have $6,414 after paying your tax: $3,000 x (1.06 ^ 20) x (1-.3333).
Taxable account
Contributing to a taxable account, you have $2,000 to invest after tax ($3,000 x (1-.3333)) and investment earnings are taxable so your effective investment return is 4% (6% x (1-.3333)). But then you’re done paying taxes. After 20 years you would have $4,382: $2,000 x (1.04 ^ 20).
What if’s: rising tax rates, capital gains, return, deferral period, Roth
In this simple example, the qualified plan clearly beats the taxable account. But what if tax rates are higher at withdrawal? For the $4,382 in the taxable account to beat the qualified plan, the tax rate would have to suddenly jump to 54.5% at withdrawal: $3,000 x (1.06 ^ 20) x (1-.545) = $4,378. Any tax increase that happens more gradually would be worse for the taxable account, with no effect on the qualified plan.
What about capital gains? If the current 15% long term capital gains rate is sustainable and all your investments qualify, your effective return is 5.1% (6% x (1-.15)). You still start with $2,000 to invest after tax, so after 20 years you would have $5,408: $2,000 x (1.051 ^ 20). That’s not bad, but it’s still less than the $6,414 you would have had from a qualified plan.
What about different investment returns and deferral periods? We’ve used 6% return for 20 years in this simple example, but how does it change for other returns and time periods? The short answer is that higher investment returns and longer deferral periods favor the qualified plan. Lower returns and shorter time favor the taxable account.
What about a Roth IRA or 401(k)? As it turns out, Roth and regular 401(k) results are identical if your marginal tax rates are equal at contribution and withdrawal. Roth is better if your marginal rate at withdrawal is higher than at contribution time; otherwise a regular 401(k) is better. And they both blow the taxable account out of the water.
These examples confirm the value of tax deferral in qualified retirement plans. As included in the examples the tax rate would have to increase to 54.5% at withdrawal to make tax deferral a bad deal. The Roth example is simple yet effective.
These hybrid retirement plans offer the business owner the opportunity to deduct income beyond the defined contribution limits. At the same time you will attract and retain talented employees.
Many successful companies (especially professional firms like medical groups and law firms) are considering whether to increase retirement plandeductions for 2011. This post highlights the action steps to take while there’s still time.Note: We’ll be focusing on cross-tested profit sharing plans and cash balance plans. These plans allow owners to make large tax-deferredretirement contributions in exchange for providing a generous employee retirement allocation (usually 5% of pay if there’s only a profit sharing plan, or 7.5% of pay if there’s a cash balance plan too).
Since the Pension Protection Act of 2006 there are numerous alternatives for deducting beyond the defined contribution limits. This can be a win win for both the employer and their employees.
Please comment or call to discuss how these hybrid plans might work for your company.
