By Eric L. Reiner
An intriguing industry white paper aimed at politicians may offer something for advisors as well.
The Tax Benefits and Revenue Costs of Tax Deferral, published by the Investment Company Institute on September 11, ostensibly rebuts those in Washington who say tax-deferred savings opportunities overly benefit high tax-bracket individuals. In doing so, the study reveals much about the benefits of saving on a tax-deferred basis.
Although the report is recent, many of its conclusions were presented three years ago at an Urban Institute gathering by the paper's author, Peter Brady. He is senior economist at ICI, the fund industry's Washington, D.C.-based trade association.
The report advocates a lifetime model for quantifying the benefits of tax-deferral. "The benefit is not equal to the up-front reduction in taxes," ICI asserts. That is only part of it. You also must factor in the tax that would have applied to the investment earnings during the deferral period, as well as the tax due upon withdrawal.
"Therefore, the tax benefits and revenue costs of deferral depend on how much investment income is generated and how much tax would have been generated by that income, which in turns depends on the rate of return earned, the length of deferral, and the character of the income," according to the report.
In other words, tax brackets are not the only variable affecting the benefit of saving on a tax-deferred basis.
It is therefore too simplistic to say that someone in the 35 percent ordinary bracket who contributes to a tax-deferred account saves 10 cents on the dollar more than someone in the 25 percent bracket. It's more like 3 cents per dollar of deferred compensation, according to ICI's math.
"A marginal tax rate higher than 25 percent doesn't add much incremental value to tax deferral. Age can be more important," software designer Ben Norquist concluded after seeing ICI's study. Norquist models deferral's benefits as CEO of Convergent Retirement Plan Solutions LLC, in Brainerd, Minn.
Immediate implications are that outsized benefits aren't accruing to America's top earners, and that the relationship between the benefits of tax-deferral and ordinary tax rates changes based on other variables.
None of this is to say that brackets don't matter. They can.
ICI points out -- and advisors may know -- when the tax rate at distribution is higher than the rate when the contribution was made, that reduces the benefit of tax-deferred saving relative to saving with a Roth account, all else being equal of course. Conversely, lower taxes at withdrawal boosts the benefits of deferral relative to a Roth.
What about no change in tax rate?
Norquist says, "The paper really drives home in no uncertain terms that if the tax rate is the same at time of contribution and at time of withdrawal, all other things being equal, the benefits of traditional tax-deferred saving and saving in a Roth are the same. That's a point not everyone grasps."
ICI concludes, "The true tax benefits and revenue costs of deferral cannot be determined at the time contributions are made. Determining the benefits requires knowledge of the benefits that accrue over a lifetime."
As with any study of this genre, the conclusions depend upon the assumptions.
ICI's comparisons of tax-deferred saving to saving in a taxable account rely on current tax laws, which may be short-lived. Barring an act of Congress by December 31, the tax landscape shifts dramatically next year with changes including the sunset of the Economic Growth and Tax Relief Reconciliation Act of 2001.
That aside, the study hits all the high points, according to Norquist. "A lot of things that we've had to consider in the design of tools are in the ICI paper. It takes a methodical approach," he says.
Advisors can decide for themselves whether the assumptions are realistic and the conclusions actionable for clients. The study is available at http://www.ici.org/pdf/ppr_12_tax_benefits.pdf.