Examining the Tax Deferral Gift Horse  

 Are tax-deferred retirement plans worthwhile?

 I apologize for asking such a rude question. But it’s time to ask.

As people who work for a living, we’ve all been told about the virtues of tax-deferred retirement plans. I’m talking about all those 401(k)s, 403(b)s and IRAs, Roth and regular.

Unrelenting advertising tells us they are essential.

Without tax-deferred plans, we will suffer an impoverished retirement. With them, our retirement will be an endless smile.

But it’s time to look this gift horse in the mouth.

 When we do, we learn that an alarming proportion of plans benefit the financial services industry and the tax man. We, on the other hand, might do better on our own, paying taxes as we go.

How could this be possible?

Simple: Things change. Two big changes have altered the economics of retirement saving.

The biggie is the introduction, and revolutionary success, of very low-cost exchange-traded-funds.

The second is taxation. Retirement plan withdrawals are taxed as ordinary income. But qualified dividends and capital gains are taxed at lower rates. In addition, our retirement plan withdrawals are increasingly likely to trigger the taxation of Social Security benefits.

Let’s start with the biggie, ETFs. Introduced in 1993, the vast majority of ETFs invest to an index. They are structured in a tax efficient way. It can impressively reduce the realization of capital gains. They also have stunningly low expense ratios compared to traditional managed mutual funds.

That cost difference reduces the value of tax deferral.

Today it is possible to build a diversified portfolio of ETFs with an average annual expense cost as low as 0.03 percent. No commissions, either.

It is easy to build a portfolio with an average cost of no more than .07 percent. That’s low enough to have minimal impact on the growth of your savings.

Financial services fees work just like a tax

The expenses of major ETFs are a fraction of the costs in 401(k) and 403(b) plans. So, it isn’t too far-fetched to consider management costs an alternative form of taxation. But the money goes to the financial services industry instead of the U.S. Treasury.

According to the “401(k) Averages Book,” a regular survey of plan costs, a relatively large plan with 2,000 participants and $200 million in assets has an average expense of 0.65 percent a year. As you might expect, smaller plans cost more: A plan with 100 participants and $50 million in assets had an average expense of 1.2 percent a year.

At those expense levels, expenses can be the equivalent of a 12 percent tax rate, or more, anytime you have a portfolio that emphasizes fixed income. Ditto any portfolio going through a rough patch.

That’s the pretty view.

Insurance companies dominate the 403(b) industry. It serves the nation’s teachers and non-profit organization workers. Those plans frequently have expenses of 2 percent a year, sometimes more.

Here’s a harsh example from the home front.  Back in 2019 the Texas Legislature voted to end the 2.75 percent expense cap on 403(b) offerings to Texas teachers. Now, fees can be higher.

You can pay more in annual investment fees than you would pay in taxes

As a result, you can be losing more money in fees than you would lose to paying taxes. In 403(b) plans like most in Texas, an annual expense of 2 percent absorbs 25 percent of an 8 percent return. Functionally, that’s the equivalent of paying taxes at that rate. Yet you pay at an income tax rate of only 24 percent in Texas if your gross income is over $102,025 for a single filer.  According to the Texas Education Agency, that’s about twice the minimum annual salary paid to a teacher with 16 years of experience.

For teachers filing joint returns, the 24 percent tax rate starts at $116,750 of gross income. Only 29 percent of Texas households earned more than that in 2021 according to the website, www.dqydj.com.

Texas teachers (not to mention Texas parents and voters) should be asking why the Texas Legislature thinks the welfare of the insurance industry is more important than attracting and retaining career teachers.

But what about having a higher return than 8 percent?

Your expense burden would be reduced, of course, by having a high return. Unfortunately, that isn’t likely. A very large majority of pension plans now target returns well under 8 percent. They have trouble meeting their targets.

How many managed funds beat their index?

Very few. As I’ve reported for many years, the Standard and Poor’s report on active management versus index funds routinely shows most managed funds fail to beat their appointed asset class index.

How serious is the failure? Try dismal, like 90 percent over a 20-year investing period.

But what about plans that have an employer match?

At first glance, the possibility of having an employer match a portion of your contribution would seem to be a generous offset for a high-expense plan. But employer matches are far less than universal. Worse, the employer match is only helpful in the early years. The more you accumulate, the more likely the higher fees on the entire accumulation will consume every bit of the employer’s annual match.

Say hello, tax man

The next barrier is two kinds of taxes. One is inevitable. The other is increasingly likely.

Tax deferral is only that, deferral. And we pay a price for that deferral: All income that comes out of non-Roth tax-deferred account is as taxable as the income that went in. But if we pay taxes along the way, the tax on the original, after-tax investment is zip when it comes out. The tax rate on qualified dividends and realized capital gains earned on the way to retirement can be as low as zero, but no higher than 20 percent. For most taxpayers, the tax rate on qualified dividends and realized capital gains will be 15 percent.

Coming out of a tax-deferred plan, however, the tax rate is likely to be 22 percent if you’ve been a diligent saver.

The Torpedo Tax

The other tax problem didn’t exist when 401(k) plans went big in 1981. Why? Because the taxation of Social Security benefits didn’t exist until 1983. Back then, the income threshold for the taxation of Social Security benefits was so high that only 3 percent of all retirees had to pay the tax.

But that was then.

Today what I called the Tax Torpedo back in 2003 hits an ever-larger portion of all retirees. The income threshold for the taxation of benefits isn’t indexed to inflation.

That’s a big deal

            Your Social Security benefits start to become taxable when half of your income from Social Security plus any other income exceeds $25,000 on a single return and $32,000 on a joint return. In December 2022, before the 8.7 percent COLA adjustment, the most common benefit check was between $2,000 and $2,099. The median payment was between $1,700 and $1,799.

            Do the math and it’s likely that any income in excess of about $12,000 a year taken from a tax-deferred plan will trigger the taxation of your Social Security benefits. Every additional dollar taken from your tax-deferred plans requires not only a tax on that dollar, but a tax on part of a Social Security benefit dollar.

            Basically, a successful qualified plan saver earns the privilege of paying a premium tax rate on what they accumulate. It’s enough to wonder why the Department of Labor doesn’t require a notice on tax-deferred plans: CAUTION! PARTICIPATION IN THIS PLAN MAY PRODUCE LESS AFTER-TAX INCOME THAN YOU THINK.

And since this tax begins and ends with Social Security benefits, it is an entirely middle-income tax. Once your Social Security benefits have been taxed, the tax is over.

So, now what?

            Figuring out what’s best is complicated.

            But I think we can formulate some rough guidelines. Here they are:

1. Don’t throw out the baby with the bath-water. Many large employers have excellent low-expense plans and provide generous matches.
2. But don’t accept claims that tax-deferred accounts will make retirement investing a cinch.
3. If your income is higher than the Social Security wage base maximum, your tax-deferred saving may work better than it does for the 94 percent of all workers who earn less.
4. If you can save on your own and you’re young, don’t be afraid to bypass tax-deferred plans. Commit to a regular investment account and go all in on a broad ETF such as the Vanguard Total Market Index ETF. You’ll pay next to nothing in taxes on your return today and mostly capital gains taxes in the future.
5. The best of all possible deals would be a Roth 401(k) invested in the lowest cost ETFs. You’ll pay no taxes on withdrawals, and withdrawals aren’t counted as income for the purposes of the taxation of Social Security benefits. (This, unfortunately, assumes that we can trust Congress. Remember, they passed the tax on Social Security benefits only a few years after opening the door to wide use of 401(k) plans. This suggests they are either nitwits or treacherous.)
6. Another good deal is a plan with an employer match and low-cost index funds.
7. The deal to avoid is 403(b) plans with high-expense options and no employer match.

Related columns:

Scott Burns, “The Incredible Importance of Social Security,” 9/6/2013

Scott Burns, “The Little Middle Class Tax That Keeps On Rising,”     8/18/2012

Scott Burns, “Two Candidates With A Nasty Secret,” 10/10/08

Scott Burns, “The 401(k) Plan Tax Trap, 2/18/2003

Scott Burns, “How the Tax Torpedo Hits,” 2/11/2003

Scott Burns, “The Retiree Tax,” 8/13/2000

Scott Burns, “An alternative to 403b plans for Texas teachers,” 9/14/2019

Scott Burns, “SPIVA: The Investment News That’s No Longer News, 6/19/2022

Sources and References:

Human Interest Team, “Average 401(k) Match,” 6/08/2020  https://humaninterest.com/learn/articles/average-401k-match/

Human Interest Team, “Different 401(k) employer match types (with examples), 1/26/2023  https://humaninterest.com/learn/articles/looking-in-depth-at-the-401k-employer-match/

Beagle, “401(k) Match of the Top 41 Employers,” https://meetbeagle.com/resources/post/401-k-match

Sarah Holden, Steven Bass, Craig Copeland, “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2020,” https://www.ebri.org/publications/research-publications/issue-briefs/content/401(k)-plan-asset-allocation-account-balances-and-loan-activity-in-2020

Simon Moore, “Pros and Cons of 403(b) Plans for Educators and Non-Profit Workers, 4/18/2018  https://www.forbes.com/sites/simonmoore/2018/04/18/pros-and-cons-of-403b-plans-for-educators-and-non-profit-workers/?sh=454d742c7ecf

Sabrina Parys and Tina Orem, “Dividend Tax Rate 2022-2023: Find Out What You’ll Owe,” 11/2/2022  https://www.nerdwallet.com/article/taxes/dividend-tax-rate

Texas Teacher Minimum salary https://tea.texas.gov/texas-educators/salary-and-service-record/minimum-salary-schedule/2021-2022-minimum-salary-schedule

Income percentile by state:  https://dqydj.com/income-percentile-by-state-calculator/

This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

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(c) Scott Burns, 2023