The Benefits of Tax-Favored Savings Plans

For most people, a traditional tax-favored savings plan will play the leading role in their retirement planning. You know: traditional IRAs, 401(k) plans, 403(b) plans. (Other types of savings buckets will be supporting actors—important contributory roles, to be sure, but no star on the door. These might include ordinary taxable accounts, Roth IRAs and Roth 401(k)’s, annuities, non-qualified deferred compensation.)

Why are traditional tax-favored savings plans so important? Because the long-term tax benefits of these savings accounts are so great, it would be a blunder to fail to take advantage of them. First, a summary. Here’s how traditional tax-favored savings buckets compare to ordinary taxable investment accounts.


How important are the long-term tax benefits. Here’s an example. Ralph and Ed are friends and neighbors and are almost identical. They are both age 37, both plan to retire at age 67, and both expect to live to age 95. This year, each of them has $6,000 to save from their salaries. The only difference is that Ralph saves his $6,000 in a traditional 401(k) account and Ed saves his in an ordinary taxable investment account. Ralph and Ed are both in the 30% tax bracket while they are working, and expect to be in a 25% tax bracket after retirement. Each expects to earn 7% return on his investments, but in Ed’s case, because of income taxes on his investment earnings, he expects to keep 5.3% during his working years and 5.5% during his retirement years. Ed can expect his one-time investment of $4,200 (= $6,000 – 30% x $6,000) to result in a $1,377 annual after-tax stream of income during his retirement. Ralph can expect his one-time $6,000 investment to result in a $2,790 annual after-tax stream of income. Ralph’s is twice as large! All attributable to the tax advantages of the savings bucket Ralph chose.

There are other differences between Ralph and Ed. Ralph is fat, and Ed is thin. Ralph drives a bus, and Ed works in the sewer. But that’s not what’s important here. What’s important is that Ralph is taking advantage of a good idea, and Ed is making a blunder.