Savings and Retirement: Where does the tax saving come from?
The tax saving in tax-favored retirement saving accounts primarily comes from the favored tax treatment of the returns on assets held within the account. Some types of tax-favored accounts tax assets when withdrawn from an account, whereas others do not, but all such accounts share the characteristic that saved assets are permitted to grow untaxed. Over time, this benefit can become substantial.
- Broadly speaking, there are two classes of subsidized retirement saving accounts: front-loaded accounts, such as traditional IRAs and 401(k)s, and back-loaded accounts, such as Roth IRAs. In front-loaded accounts, contributions are tax-deductible and withdrawals are taxed. In back-loaded accounts, contributions are not tax-deductible but withdrawals are not taxed. In both types of accounts the investment returns on assets kept within the account are untaxed.
- Whether taxpayers benefit more from a front-loaded or a back-loaded account depends on the difference in tax rates during their working years and in retirement. Someone with a high tax rate during his or her working years and a lower tax rate in retirement would benefit more from a front-loaded account, since the original contribution is deducted against a high tax rate and the withdrawal is taxed at a lower rate. Someone whose tax rate is expected to be higher in retirement would benefit more from the back-loaded account.
- An additional consideration is that one can effectively shelter more saving in a back-loaded account than in a front-loaded account if the two accounts have the same contribution limit. For example, if an individual facing a 25 percent marginal income tax rate contributes $1,000 to a front-loaded account, she is really contributing $750, or (1.00 - 0.25) x $1,000 of her own funds, and $250 of government funds because of the tax deduction. When the funds are withdrawn, the government reclaims its share of the amount withdrawn. In contrast, in a back-loaded account, the entire amount grows tax-free and can be withdrawn tax-free.