Saving in a Tax-Deferred Account Only Increases Your Taxes?

Last Updated Dec 2, 2009 8:58 PM EST

Of all the illogical statements I've heard from so-called financial planners, my favorite is the advice that investors shouldn't put money in IRA or 401(k) accounts. The logic-twisted-into-a-pretzel reason they give is:
Pretax retirement plans do not save income taxes. In fact, you end up paying far more in taxes which is just what the government wants.
To back up this statement, they will often run through some numbers that seem to prove that you do, in fact, end up paying more in taxes. And while what they're saying may be true, it's also completely irrelevant.

Your investing goal isn't to pay lower taxes

If your goal is strictly to pay less in taxes, I've got a simple solution; just don't earn any money! Most people have a much better goal, which is to maximize their after-tax dollars.

I think of tax-deferred investing as the U.S. government giving us a loan at a zero percent interest rate. Someone in the 28% marginal tax bracket that puts away $10,000, gets to use that $2,800 they would have paid in taxes and earn on that money until they withdraw. If the $10,000 doubles, their taxes will also double if they stay in the same tax bracket.

But aren't tax rates going to rise?


I don't predict what Congress is going to do with taxes, but it is certainly plausible that tax rates will increase by the time you withdraw your funds. Yet this doesn't necessarily mean you will pay more in taxes.

Presumably, you won't have an earned income as you will be retired. Thus, even 10 percent higher tax rates don't necessarily mean your marginal tax rate will be higher since your income will be lower.

A better way to hedge against increasing tax rates

Rather than avoid pre-tax retirement plans, I urge clients to use both traditional and Roth vehicles. Having both helps diversify us from what Congress may ultimately do to tax rates. If increases are high, the Roth may be the better vehicle. If increases are only moderate, or if we ultimately go to a consumption tax, the traditional will have been the better choice.

Why some planners give you the garbage advice of avoiding tax-deferred investing

If you invest in your company's 401(K) plan, financial planners generally can't make any money on this part of your portfolio. Many financial planners want to sell you insurance investments or mutual funds that pay them commissions. Even fee-based planners that charge a percentage of assets are better off by capturing your money, rather than letting you invest in your company plan.

My advice
Most planners will tell you to make sure you capture the company match, though I generally recommend going much further. Put away as much as you can in tax-deferred and tax-free Roth vehicles. Keep costs low and locate your assets in the right vehicles, to insure paying lower taxes.

And always be skeptical of self-serving advice. In good economic times and bad, there is never a shortage of people cooking up ways to separate you from your hard-earned money.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.