Conventional wisdom says that a high-income taxpayer should contribute the maximum amount to their 401k plan. True, it does decrease their current taxable income (the contributions to 401k are deductible against earned income), but it can cause a major tax headache later.
First, the assumption is that their income will go down in the future (but it could go up for a number of reasons). If they listen to most advisors, they state that that people’s income will always go down when they retire.
But, there are some people who plan to retire with more income than they have now. For them, a 401k plan that defers tax to a later date doesn’t make sense. They’ll make more money—which mean they’ll pay more tax!
Not to mention that it’s very likely that taxes will increase in the not too distant future. Why pay tax purposely at a higher rate?
The second reason why a 401k plan doesn’t make tax sense for a high-income taxpayer has to do with how we pay income tax. There are three types of income: earned income (you work for your money), passive income (your investments work for you), and portfolio income (your money works for you).
Portfolio income is primarily from capital gains, which is typically the type of income you will earn from investments. The capital gains tax rate is roughly 20 percent. However, the federal tax rates for earned income (ordinary income) can be as high as almost 40 percent.
If the high-income taxpayer holds their investments outside of a 401k, the tax rate on gains would be roughly 18 percent to 20 percent. If, however, they hold these investments inside a 401k, the tax is deferred until they withdraw the income. That withdrawn income is ordinary income, taxed at the highest rate.
That means a 401k plan doubles their tax rate from the capital gains rate (18-20 percent) to the ordinary tax rate (roughly 38 percent).
Even worse, let’s assume that the person dies with money still within their pension plan. Upon their death, the pension plan is taxed for income and estate taxes. The total tax on an average estate would be 75 percent.
For example, if that person’s pension plan started out with $100K and grows to $400K, this means that only $100K is available for their heirs. The net gain on this 401k plan plan (which quadrupled in amount) is actually zero!
There might be benefit to deferring tax to the future, but you must make sure that the solutions support the goals for the future. Don’t settle for conventional advice from conventional advisors.
