Are IRAs, 401ks Still Good Ideas?

Many aspects of retirement planning changed over the last decade. One piece of conventional wisdom that has endured is to maximize contributions to IRAs and 401(k) plans. I’ve questioned that in the past, and it is time again to question this advice.

IRAs and 401(k)s are tax shelters. Changes in the tax law alter the benefits of these plans. There are two recent changes individuals need to consider before maximizing deferrals of money into these accounts.

The first change, or group of changes, is the 2003 tax law. It lowered tax rates on current ordinary income, dividends, and long-term capital gains. The reductions in taxes on long-term capital gains and especially on dividends were deeper than the ordinary income tax cuts. Thee changes all reduce the benefits of tax-deferred compounding through IRAs and 401(k)s.

The second change is the tax rate you will face in retirement. It used to be a given that almost everyone would face lower tax rates in retirement than during the working years. Today, retirees often are in the same tax bracket as during their working years. It is not unusual for the tax rate to rise in retirement. As the article on page 7 explains, there might be special reasons to expect future tax rates to be higher.

Those saving for retirement have to consider when it makes sense to use 401(k)s and IRAs and when they should stick with taxable accounts. Here is my research and some guidelines for making the decision.

Roth IRAs do not figure into this discussion. Retirement distributions from them are tax free. The only change to be wary of is the possibility that a future Congress might decide to make the distributions taxable.

A 401(k) plan to the extent it has meaningful employer contributions also is a good bet. The employer contribution is an additional return on your money. It would take substantial future tax increases to erode this benefit. If your employer matches contributions, make contributions up to the match limit.

Now, let’s consider non-deductible IRAs. Higher income taxpayers are not allowed to deduct contributions to an IRA. So, both IRA and taxable account investments are made with after-tax dollars, and withdrawals of the contributions are tax free. Earnings of the IRA are not taxed until withdrawn, then they are taxed as ordinary income. That is a disadvantage of the IRA. Dividends earned in the taxable account currently are taxed at 15%, as are long-term capital gains. Taxes on capital gains in the taxable account can be deferred until assets are sold. Thus, the taxable account can defer taxes for a long time and have distributions taxed at a maximum 15%.

Unlike in the past, it is a close call whether the nondeductible IRA and 401(k) contributions beyond the employer match level are a better deal than the taxable account. Much depends on the investment strategy and assumptions about future tax rates and investment returns. If the taxable account is invested so that few taxes are paid during the accumulation years and taxes are paid at the long-term capital gains rate, then the taxable account will generate about the same or more after-tax wealth than the tax-deferred account. The taxable account might generate significantly more after-tax wealth.

Of course, if you assume that capital gains rates rise but ordinary income rates do not, then the disadvantages of the tax qualified accounts are reduced.

The IRA and 401(k), however, are locked in and less flexible. With the uncertainty and lack of flexibility of the IRA, the taxable account could be the safer, more profitable choice.

What about a deductible IRA? The merits of the IRA versus a taxable account depend on what is done with the tax savings from the deduction for the IRA contribution. If the tax benefits are spent on non-essential, depreciating consumer items, then the results are the same as for a nondeductible IRA. It would be better to forego the deduction and invest the money in a taxable account. But if the tax benefits are invested in a taxable account, contributing to the IRA often will generate greater wealth over time.

But someone who can make deductible contributions to an IRA also is likely to be eligible for a Roth IRA. The Roth IRA is the better deal and should be used by anyone who is eligible for it. It is preferable to a deductible, traditional IRA.

As you’ve seen, under today’s crazy tax code your retirement wealth can be increased simply by shifting investment contributions from one type of account to another.

Here are some basic guidelines to follow when choosing investment vehicles.

• Anyone who is eligible to contribute to a Roth IRA should do so before contributing to another type of IRA or a 401(k). 

• If your employer matches deferrals to 401(k) plans, defer salary into the 401(k) up to the maximum matching level. 

• Over the long term, investing through a taxable account might be better than making nondeductible IRA contributions or unmatched contributions to a 401(k). A tax-wise investor who invests for long-term capital gains and tax-favored dividends benefits from a taxable account. Someone who earns mostly short-term gains, interest, or non-qualified dividends still would benefit from the tax-qualified accounts. 

• Deductible IRA contributions clearly are advantageous only when the tax benefits of the deduction are invested instead of spent. Otherwise, the results aren’t different from those of a non-deductible IRA.