Thursday, August 09, 2007

IT DOESN’T ALWAYS PAY TO MAX OUT ON RETIREMENT PLAN CONTRIBUTIONS

The conventional wisdom is that taxpayers should contribute all that the law allows (but of course, no more than they can afford) to tax-deferred retirement plans. This allows for a current income tax deduction for the contribution (and thus instant savings on income taxes), and deferred income taxes on growth on the contributed assets.

However, the conventional wisdom is not always correct. Some number crunching CPA's have confirmed that older workers may be better off not contributing everything they can. This is due to the confluence of several factors, including (a) mandatory minimum distribution requirements that require distributions to made soon after retirement, which distributions will be taxable, and (b) the fact that under current law, the current rates of income tax are slated to materially increase in 2011. Thus, current income tax deductions at today's lower rates will result in higher taxes when paid out of the retirement account at later higher rates.

For this to occur, however, the assets not transferred to the retirement plan would need to be invested in a low tax investment, such as long term investments in securities that are taxable only on sale. Otherwise, the tax benefits of deferring current investment income in the retirement plan will again swing the computation in favor of making a deductible contribution to the retirement plan.

Of course, if a taxpayer loses out on employer-matching of contributions to a retirement plan by not making their own contribution, then the balance will also swing in favor of making the retirement plan contribution.

Source: Baxendale, Sidney J. & Levitan, Alan S., Reduce Pre-Tax Retirement Contributions For More After-Tax Wealth, Practical Tax Strategies (July 2007)

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