For nearly 30 years, employees have been coached that the best way to save for retirement is to take advantage of tax deferred investing, most prominently through their 401(k) plans. This strategy has always been anchored in the hope that lower tax brackets await us during our retirement years. But current economic realities are causing many in the financial community to question whether tax deferred saving remains a healthy long term strategy for employees.
When 401(k) plans were first rolled out in 1981, the income tax rates and bracket structure were very different than today. The top federal tax rate was nearly 70% and there were 15 different income tax brackets separated by just a few thousand dollars of income (See Tax History). Given those conditions 401(k) contributions presented a great opportunity to both avoid high current rates and reduce W-2 income in the contribution year just enough to move into a lower bracket. So it seemed like a double win, lower taxes in the contribution year and in the future, when the Plan was accessed during retirement.
Since 1981 the sustained effects of “Reaganomics” led to a steady decline of both tax rates (highest federal bracket from 70% to 35%) and the number of brackets (from 15 to 6). During this period, with few exceptions, the US economy experienced robust economic growth. 401(k) Plans got even better as a result. To attract and retain employees, employers with healthy bottom lines began to offer generous matching incentives linked to 401(k) participation.
But the length and depth of the current recession is now changing the outlook for today’s 401(k) savers in two significant ways. First and most importantly, the government funded stimulus packages and propensity to grow overall government spending must be paid for at some point. This future “balance due” can only offset by higher taxes or a devaluing of the dollar (inflation). The second effect of the current recession is that many companies have cut back or eliminated matching 401(k) contributions.
So the question for the employee now becomes, “if I no longer receive any company matching, and I may have to pay higher taxes on withdrawals in the future, is the 401(k) still the right way to save?”
Enter sound savings principles and the Roth 401(k) to the rescue. Match or no match, automation and consistency are two key factors in any saving’s strategy. 401(k) plans are still great because the money is automatically deducted from every paycheck before it can get spent. The recently introduced Roth 401(k) addresses the more daunting issue of higher taxes in the future by allowing after tax contributions now and tax free retirement withdrawals in retirement.
So rather focusing on the now suspect virtues of tax deferral, maybe it’s time to pitch the 401(k) as primarily a great way to save, period. Wise portfolio allocations and a balanced approach between the Traditional 401(k) and the Roth 401(k) will address the constant winds of change that remain outside of the investor’s control.
