There is a lot of news going around after an opinion article appeared in Bloomberg this past month arguing that, due to changes in the tax code and common investment fees, saving and investing in your 401(k) is no longer a good idea for many individuals. But is that true?
Part of it depends on what data you use. And part of it depends on if your only reason for saving is to avoid taxes.
One of the major tax benefits of putting your hard-earned dollars into a 401(k) plan (or an IRA, if your employer doesn’t have such a plan) is that your contributions are tax deferred. You don’t pay taxes on those earnings now, and won’t pay taxes on those earnings as they grow. You will only pay taxes in the future when you take funds out of your 401(k) to spend in retirement.
A tax deferral is more valuable the higher income taxes are and the higher expected inflation is, and less valuable the higher fees are to invest the money. The author of the Bloomberg articlewas arguing that taxes and inflation are so much lower, and fees so much higher, that the benefit of having a 401(k) plan has disappeared.
Many in the financial sector have taken issue with the particular numbers used by the author for tax rates, inflation, median income and so forth and claim that the tax benefits are still there. But if the tax benefits were gone, would the reason for saving in a 401(k) disappear as well?
We would argue the answer is absolutely not.
The Power of Saving
That is because there is value inherent in saving itself. You’ve probably heard the phrase “compound interest is the most powerful force in the universe” (supposedly uttered by Einstein) numerous times. And it may well be true!
Imagine a world in which a diversified portfolio earns 6% each year (as an example). Now imagine you save $10,000 today. After one year, you will have $10,600. Now let’s say you keep reinvesting your earnings for 50 years but don’t add any more money.
After 50 years, you might expect to have grown your money merely by 6% x 50 = 300%.
But not so! You see, your earnings have been increasing as well, compounding the interest you earn. No, your $10,000 saving, in 50 years, would be worth $184,201.54, which is a 1700% increase from your original investment.
That’s the power of compound interest.
And how many times did I mention the word “taxes” above?
That’s because it doesn’t matter to the growth whether you avoided taxes on the $10,000 before you started investing (as long as you are not taxed every year on that growth, which doesn’t happen in an IRA or 401k).
There is value in saving even if your “tax advantage” at the outset is not as big as it once was.
But saving takes practice, and starting a saving routine by taking advantage of your employer’s 401(k) or your own Individual Retirement Account (IRA) can pay dividends down the road.
In addition, not everyone who saves should even be thinking about the tax advantage at the beginning; that’s why there is a Roth IRA.
The Roth IRA: when tax-exempt is preferable to tax-deferred
Many savers don’t even use a Traditional IRA or 401(k), instead putting their savings into a Roth IRA or Roth-designated 401(k). Unlike a traditional 401(k), the savings you contribute to a Roth IRA aren’t deducted from your taxes today. But the contributions and gains become tax-exempt, meaning you will never pay taxes on them again, not on the growth and not if you withdraw in retirement after age 59 ½. There are also certain qualified withdrawals after 5 years such as for a first-time home purchase or qualified educational expenses that make Roth accounts very attractive for certain younger savers.
Roth IRA and 401(k) accounts have proven useful saving tools for those who expect that their income tax brackets at retirement might be higher than those brackets today or who are thinking about possibly purchasing a first home or going back to school in the future.
For these savers, the concept of a “tax advantage” based on their current income bracket is not even part of the equation, let alone whether that advantage has “eroded” since the 1970s!
“Free money”: the Employer Match
And lastly, of course, there is another advantage that is unique in the case of the many types of retirement plans at many companies, including ones that small entrepreneurs can set up for themselves. These have a variety of acronyms: 401(k), SIMPLE IRA, SEP IRA, 403(b), etc. What all of them have in common is that there is an employer contribution or match in addition to your contribution as the employee saver!
We like to call this “free money.” If your employer is going to match your saving contribution up to, as an example, 3% of your salary, then that 3% additional salary each year is well worth it, even if there is less of a “tax advantage” than there was decades ago.
Furthermore, let’s say your 401(k) plan does indeed have fees of up to 2%, all costs considered. That 2% fee is applied on your contributions, which means that, after fees, your “free money” of a 3% employer match is now a 3% x (1-0.02) = 2.94% “free money” employer match.
That is still a 2.94% additional contribution that didn’t have to come out of your own salary!
Saving Still makes Sense
Is it true that tax rates and inflation are lower now than they were in the 1970s? Yup. And is it true that there are fees and financial costs associated with investing in the markets or having someone take care of your 401(k) plan or IRA for you? Yup.
But saving money for the future isn’t just about trying to take advantage of tax deductions today. Some savers never take those tax deductions today because a Roth IRA makes more sense for them.
Saving is about using the power of compound interest, and (in cases where your employer matches) the benefit of “free money”, to be prepared for retirement.
Today we have a lot of human capital (our ability to do work for pay); in the future we will have less, and we will prefer to use that human capital for leisure instead of for work! Which means we will need to replace that human capital with financial capital. That’s what saving and investing is.
Looking just at “tax advantages” is missing the big picture.
Saving still makes sense.