Tax-Favored Retirement Plans: The Tax Time Machine

In yesterday’s post, I summarized the income tax differences between saving in an ordinary taxable investment account and in a traditional tax-favored retirement account. I think it’s a good idea to step back a second and see what that implies about income taxes over your entire lifetime.

A traditional tax-favored savings bucket (an IRA, a 401(k) account, a 403(b) account) acts as your own personal income tax time machine. It shifts a piece of your salary—and the payment of income tax on that portion of your salary—from the Present You to the Future You. The deduction you get causes your annual savings to disappear from Present You’s tax return, and then just pop up on Future You’s tax return. Just like the DeLorean in Back to the Future!

And that has implications for your retirement planning. An astute commenter named Anonymous pointed out in a comment to January 21’s post that it’s a big mistake to fail to take into account income taxes when coming up with a savings target. And indeed it is. But if you do your saving inside a tax time machine, then in fact you are indirectly taking income taxes into account.

Remember the example of Ernie? Ernie started (in January 16’s post) by looking at his gross salary of $100,000 and subtracting a couple of expenses to see what he is currently living on. Included within his current standard of living are his state and federal income taxes. A lot less satisfying than food and vacations, for sure, but a living expense nonetheless. Let’s say they add up to $10,000. Since his planning is aimed at having Future Ernie enjoy the same standard of living, he can expect Future Ernie’s income tax expense to be roughly the same $10,000. The tax time machine will make that happen. So Present Ernie’s after-tax standard of living and Future Ernie’s after-tax standard of living will also be roughly the same. And that’s his goal.

For sure, there will remain some small differences between Present Ernie’s taxes and Future Ernie’s taxes. But they are likely not significant. For example, a portion of Ernie’s Social Security benefit is not taxed. And Future Ernie might not have a mortgage interest deduction. But these differences are likely not material.

So, like Ernie, you too can evade the awful, complex task of actually figuring out your present and future income taxes. But this only works if, like Ernie, substantially all of your retirement saving is expected to occur inside traditional tax-favored retirement accounts. That won’t be the case if for whatever reason your annual savings goal exceeds the amount you’re allowed to put into these types of plans. For example, if you get started saving late in life, or if you have a really high salary, or perhaps if your cheapskate employer doesn’t offer you a 401(k) plan. If a meaningful portion of your savings ends up in an ordinary taxable investment account or a Roth account, you’ll have to do some fancy footwork to deal with the income tax differences between the Present You and the Future You.

How do you make these adjustments to your planning? That’s another post altogether.