401(k) Tax Deferrals May Backfire

An interesting study released by the National Bureau of Economic Research, demonstrates how 401(k) funds set aside for retirement and tax deferred when earned, may end up actually costing the investors more in tax dollars than if the funds were taxed at the time they were earned.

Low- and middle-income workers might be most victimized by a potential retirement scenario in which income from mandatory withdrawals from a 401(k) plan pushes the taxpayer into a higher tax bracket, raising the marginal tax rate and potentially hiking to 85% the amount of Social Security benefits that are subject to income tax.

Workers who invest in 401(k) plans assume they will be in a lower tax bracket when they retire. By deferring the tax on the income that is deposited in 401(k) plans, and on the earnings of these plans, workers assume they will save money.

The study points out that often taxpayers are experiencing high deduction years at the time when they are earning money which is placed in tax deferred funds. By reducing their income with the 401(k) deferral plan, these workers may lower their tax bracket and thus inadvertently reduce the value of their tax deductions.

The main point of the study is that financial planning for retirement is a complex matter and many angles must be considered. Copies of the study are available for $5 from the National Bureau of Economic Research.

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