Ed Slott says traditional 401(k) tax deductions aren’t real tax deductions. He claims that traditional 401(k) deductions are not real deductions because the deducted amount and future growth must ultimately be taxed at a later date.
My view is different. Not only do I believe traditional 401(k) tax deductions are real tax deductions, I go further. I believe that traditional 401(k) tax deductions are the best tax deductions!
Keep reading to find out why.
A Brief Note on Terminology
Before we proceed, I and other financial advisors often use the term “deduction” when the more technically appropriate term is “exclusion.” At W-2 jobs, employee contributions to traditional 401(k)s (and traditional 403(b)s, 457s, and SIMPLE IRAs) are not deducted from taxable income. Rather, they are excluded from W-2 income. There’s no “deduction” to take. Rather, W-2 income is reduced because the contribution to the traditional 401(k) is excluded from W-2 income (see Box 1 of Form W-2).
Nevertheless, I believe that it is appropriate to use “deduction” as a colloquialism for the tax effect of a traditional 401(k) contribution. From a planning perspective, there’s no real difference between an exclusion and a deduction that reduces adjusted gross income. Further, those not in the personal finance industry might be confused by the term “exclusion” but tend to understand the meaning of “deduction.”
Note that for Schedule C solopreneurs, employee traditional Solo 401(k) contributions and traditional SIMPLE IRA employee contributions are deducted on a tax return on line 16 of Schedule 1. Self-employed employee contributions are not excluded from Schedule C income.
Comparing and Contrasting Tax Deductions
Let’s consider the three most common itemized deductions.
- Home mortgage interest is paid to the bank
- State and local taxes are paid to state and local governments
- Charitable contributions are paid to charities
Yes, the person gets a tax deduction. But they don’t get to keep the money! The bank, a charity, or a government keeps the money.
This is generally true of business deductions as well. People talk about “bonus depreciation” but all that means is the timing of the tax deduction is more advantageous. The vendor or contractor still got the money!
What about the deduction into the traditional 401(k)?
You get to keep the money! Yes, the money legally goes into a 401(k) plan. But later in life, perhaps not that much later in life, the money and its growth is yours!
To my mind, the best deductions are the ones I keep! That is much better than the bank or the county government getting the money. I favor deductions I keep even if I have to later include that amount and its growth in taxable income.
I like myself more than I like the bank!
No offense to the bankers reading this.
Do You Get to Enjoy All the Money in a Traditional 401(k)?
You might be reading this and thinking:
Wait a minute, Sean. There’s no way I will ever personally spend every last penny of a multimillion dollar retirement account. I won’t “Die with Zero.” How then do I ‘get to keep’ the amount I deducted into the traditional 401(k)?
You are correct in terms of actual spending. Will every last penny of your traditional 401(k) go to upgrade you and/or your spouse to a junior suite at the Fairfield by Marriott?
No.
But I contend you get to benefit from every last penny in that traditional 401(k) to a greater extent than buying hotel room upgrades.
Every last penny in your traditional 401(k) supports you as you make the most important financial decisions.
When you are considering when to retire, what do you look at? One of the most important numbers is the amount in your traditional 401(k). The greater that number, the more likely you are to be able to decide to retire.
Without spending a penny of your traditional 401(k) balance, your entire traditional 401(k) balance benefits you when making one of the most important financial decisions you’ll ever make–the decision to retire!
Compare the deduction that can help you make a positive retirement decision to the deduction paid to the bank, paid to the state government, or paid to charity. Outside of a paid off home supporting a positive retirement decision, those deductions have no value to you when you’re looking at your current wealth and trying to make a retirement decision.
Deferring Tends to Reduce Both Tax Rate and Tax Impact
Now you might be thinking:
Sean, sure, your traditional 401(k) balance helps you achieve retirement and other financial goals. But don’t you pay more in taxes by deferring?
For the vast majority of Americans, deferring is the key to reducing taxes. It’s the Pay Tax When You Pay Less Tax concept Cody Garrett, CFP(R) and I discuss in our book Tax Planning To and Through Early Retirement.
Americans tend to pay income taxes at their highest lifetime rates during their working careers. Retirement tends to be accompanied by significant tax cuts. Said differently, retirement tends to be a great time to pay tax because it’s the time most Americans, even most affluent Americans, pay less tax.
On my YouTube channel, I’ve demonstrated that retirees, even very affluent retirees, tend to be lightly taxed. See, for example, a 60 year old retired couple, an 80 year old with RMDs on a $500,000 traditional IRA, an 81 year old widow with RMDs on a $1 million traditional IRA, and an 80 year old married couple with RMDs on a $2 million traditional IRA.
Thus, deduction for traditional 401(k) contributions tends to reduce lifetime taxes. The deduction often enjoys a tax rate benefit greater than the tax rate paid on traditional retirement account distributions in retirement.
Impact of Tax Paid
Outside of unique situations, you or your heirs have to pay tax on retirement account contributions. That tax is paid during one’s career if they choose Roth 401(k) contributions. That tax is generally paid during retirement if one chooses traditional 401(k) contributions. Traditional 401(k) contributions are also likely to trigger some tax paid by beneficiaries after the original owner’s death.
The tax has to be paid (well, it has to be paid in most but not all cases — for example, see these exceptions). When is paying that tax most impactful?
Traditional 401(k) contributions tend to blunt the impact of taxes paid. It gives workers a tax deduction when they need it most: before they’ve accumulated sufficient assets for financial independence or retirement and perhaps when they are paying off their mortgage and feeding their kids.
Compare that to the profile of affluent retirees in their 70s or 80s. These are people who have met their financial goals. Yes, they pay taxes on RMDs. But those taxes have much less impact on the successful retiree’s lived experience than the taxes saved have on a 30-something or 40-something worker trying to pay off the mortgage, build up retirement savings, and possibly feed some kids.
The person electing to pay taxes later in life, which is what a traditional 401(k) contribution does and what avoiding a taxable Roth conversion in one’s 50s or 60s does, elects to pay taxes when taxes are least detrimental–in old age.
In old age either the person will be only moderately financially successful (or worse) and thus will likely have very little in the way of federal income tax, or the person will be very financially successful and any federal income tax is too late to derail their financial success or materially impact their lived experience.
Is it better for your 30- or 40-something self to pay taxes or is it better for your 80-something self to pay taxes?
When our heirs pay tax on our traditional retirement accounts, they pay tax on a windfall. Regardless, they are still the beneficiaries of a windfall, making it unlikely that taxes on the windfall will derail their financial future.
Conclusion
My opinion is the best tax deduction is the one I keep and the one most likely to lower my lifetime tax burden. That’s the contribution to a traditional 401(k) at work.
FI Tax Guy can be your financial planner! Find out more by visiting mullaneyfinancial.com
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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, legal, investment, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.