Using a 401(k) (or other tax-deferred retirement account) can be a fantastic way to save for retirement. However, who gets the most benefit out of using it? It turns out that the law of diminishing returns definitely applies to 401(k)s. Let me show you what I mean.
The Minimal Saver
Imagine a doctor who has never saved anything for retirement. He has a 33% marginal tax rate and his employer matches the first $10K he puts into his 401(k) each year. The first few dollars he puts into a 401(k) have a huge benefit for a number of reasons.
First, he gets the match. Instant 100% return on his money.
Second, since he isn't going to have much saved for retirement, he has a huge marginal utility of wealth for those saved dollars. While it doesn't make a big difference to go from $120K in retirement income to $125K, going from $30K to $35K might be the difference between Alpo and the organic food store.
Third, the smaller your tax-deferred retirement account, the less income you can take from it in retirement. Our income tax system is progressive, so the first dollars of income you have aren't taxed at all. In fact, for many low earners, they basically have negative taxes once you include all credits and government benefits. But at any rate, for our doctor with a current marginal rate of 33%, who can pull out much of his money at 0%, 10%, and 15% in retirement, there is a huge “tax arbitrage” there for him to take advantage of.
The Great Saver
Take another physician, however. He might have the same income as the first doc. However, he's a good saver and a good investor. He stuffs his tax-deferred retirement accounts full. In fact, he puts so much in there that his marginal tax rate falls to 28% during his peak earnings years. He saves a little money on the side as well, which he invests in real estate which he expects to kick out a pretty good income in retirement. He works until 70 or so and then finds out he's got a $7 Million tax-deferred IRA. Let's say that between Social Security and his real estate investments that he's got a taxable income of $120K. The Required Minimum Distribution on that is $252K and growing. If you only took the standard deduction, what would your marginal tax rate be? 33%. Putting money into your 401(k) at 28%, and taking it out at 33% is obviously less than ideal. Many insurance salesmen love to use this “retirement tax trap” possibility to scare people out of using a 401(k) at all, or worse, pulling all their money out of their 401(k)s, paying tax and penalties on it, and investing it into their favored investments. Obviously, most people and most physicians aren't going to have a retirement tax trap. But a few really good savers who don't take the time to get some tax diversification might.
Somewhere In Between
Of course, most physicians are going to be somewhere in the middle. The closer you are to the terrible saver, the more benefit you're going to see from putting money into your 401(k). The closer you are to the great saver, the more consideration you should be giving to things like Roth 401(k) contributions and Roth conversions. Tax-deferred savings is awesome, but it becomes less awesome the more you do it.
What do you think? What is the difference between your marginal tax rate now and what you expect to be able to pull your tax-deferred money out at? How will you decide when to do Roth conversions or make Roth 401(k) contributions? Comment below!