Middle Class Tax Break?

One thing that really bothers us is when popular press financial writers do not understand basic finance. For example, this article argues that the deductibility of 401k deposits decreases tax revenue by $163 billion. While we are sure that the author got the numbers used from another source, the fact that this number is used shows little understanding of finance. In fact, the deductibility of retirement account deposits actually increases tax receipts. Suppose you deposit $5,000 into a 401k. In the 30 percent tax bracket you would save $1,500 in taxes today. In 30 years at a 10 percent interest rate you would have $87,247. If you withdraw all of the money, you would pay $26,174 in taxes at the same 30 percent tax rate. Guess what the future value of $1,500 today for 30 years at 10 percent is? You got it --- $26,174! The tax deductibility of the deposit does not affect the tax receipts, only the timing of the tax receipts. At a 10 percent interest rate the NPV of the taxes is zero. Further, compared to a taxable account, the tax deductibility and tax deferral in a 401k actually increases tax receipts in the long run. The reason is that in a taxable account, all capital gains would be taxed at the capital gains tax rate, which is lower than the income tax rate for most people. In a 401k, the capital gains are taxed at the higher income tax rate, resulting in greater tax receipts.