Age greater factor than tax rates in determining benefits of plan contributions, ICI study finds

Individuals’ ages are typically more important than their marginal tax rates in determining how much they benefit from the deferred taxation of compensation contributed to employer-provided retirement plans, according to a study released by the Investment Company Institute (ICI). The study, “The Tax Benefits and Revenue Costs of Tax Deferrals,” found, for example, that in realistic simulations for a variety of investments, the tax benefits from a one-time $1 contribution to a retirement plan are greater for a 45-year-old with a 15% marginal tax rate than for a 60-year-old in the 35% tax bracket.

Tax treatment of retirement savings vs. health benefits

The ICI report emphasizes that the tax treatment of retirement plan contributions is very different from that accorded to employer-provided health benefits. Retirement plan contributions are tax-deferred whereas employer-provided health benefits are excluded from income. The ICI study notes that, unlike income that is excluded or deducted, deferred income is eventually subjected to tax when it is withdrawn from a retirement account.

Because of this difference, the benefits of tax deferral cannot be calculated in the same manner used to determine the benefits of an exclusion or deduction—by simply multiplying the amount of the exclusion or deduction by the individual’s marginal tax rate. For tax-deferred retirement investments, according to the ICI, “the benefits calculation is not just a function of the individual’s marginal tax rate.” Rather, the study concludes, “one must assess the effects of deferral over time.”

Factors that influence the benefits of tax deferral

“Marginal tax rates are just one among a number of factors that influence the tax benefits of contributing to retirement accounts. Other factors include the length of time contributions remain invested, the rate of return earned on investments, and the type of investment income generated,” said Peter Brady, ICI senior economist and author of the study. “As Congress considers tax reform next year, it is critical that policymakers understand the true nature of the benefits that retirement savers get from tax deferral.”

The study shows that, ultimately, tax deferral is roughly equivalent to exempting from tax the investment income earned on retirement contributions. In addition, the study illustrates that the relationship between marginal tax rates and the tax benefits of deferral is complex. In general, the benefits of tax deferral (and the revenue costs) do not increase proportionately with individuals’ marginal tax rates, and can actually decline as marginal tax rates increase.

For example, the ICI notes, if $1 of compensation were contributed to a retirement plan and invested in corporate stocks, then all else being equal, an individual subject to a 25% marginal tax rate typically would benefit more from the deferral of tax than would an individual with a 35% marginal tax rate.

Source: ICI press release, September 11, 2012.

For more information, visit http://www.wolterskluwerlb.com/rbcs.

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer’s Benefits Reports.

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