The vast majority of us have the option of saving into a tax-qualified retirement vehicle through our employers, typically a 401(k) or 403(b). There are other variations, but it isn’t necessary to our topic. The question becomes: “Should I save into my company’s 401(k)?”
I believe the real question to be: “Should I pay taxes now or later?” Taxes are the largest expense that we have in our lifetime. Every investment decision made must consider the tax consequences now and in the future.
Let’s consider the current federal marginal tax rates. If you compare them to historical rates, we are actually on the low end of the spectrum. Does that mean they are definitely going up? No. However, consider our national debt. It amazes me how we throw the word trillion around like it’s an everyday number. Any idea what year it was a trillion seconds ago?… Close to 30,000 BC. That’s crazy. Our current national debt is over 17 trillion… sort of. It’s actually much higher because the federal government is allowed to use accounting practices that no one else can.
Secondly, let’s look at Social Security. In 1955 there were nearly 9 people contributing for every one person taking benefits. At this time there are less than 3 people contributing for every benefit taker. Also, the government likes to borrow from the Social Security trust fund.
What does this mean? Simply stated, the government has to either spend less or tax more. What do you think they are most likely to do? Me too.
Back to the original question. “Should I save into my 401(k)?” My answer is yes, most of the time. How much is more important of a question than if. If you receive any match at all, you should definitely take advantage of the free money. Free money is the best money. After capturing that full match, we must then take a look at our tax consequences. (For illustrative purposes, let’s assume your 401(k) doesn’t offer a ROTH option, since most do not). When do we need the tax break, now or in the future? Money saved now on a pre-tax basis grows tax-deferred, and is taxed as income when taken out. I wish I could tell you what your tax rate will be in retirement, but I can’t. However, if we consider what drives these tax rates, I feel it’s a safe assumption that it will be higher than it is now.
So, what does this mean? We need to diversify (from a tax perspective) the vehicles we use to save for our retirement income. Our goal for our clients is to set up pots of money that allow us to limit taxes now and in retirement. How nice would it be to have a huge chunk of your retirement income be tax free? Sounds good, right?
There is no cookie cutter answer to the original question. It truly depends on your particular situation. My plea is that you consider taxes as you make your 401(k) decisions. In a lot of cases, it makes more sense to pay the tax today, instead of in retirement.