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This article is in response to Kerry Pechter’s article, The Ambiguity of Tax Deferral, which appeared on December 4, 2017 and the SSRN paper it referenced. In contrast to the idea that there are different, but valid, ways to look at traditional tax-deferred 401(k) and IRA accounts, I show that there are right and wrong conceptual models. Wrong models lead to wrong decisions and do not explain outcomes. When evaluating the government’s costs for these accounts, it must be acknowledged that the benefits to savers are different from the costs to taxpayers.
The correct conceptual model
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The scientific method requires that a model explain and correctly predict outcomes. Since the purpose of a tax shelter is to reduce income taxes, the model must explain and predict the value of taxes saved. A proxy for taxes saved is the excess ending wealth versus a normal taxable account. The model shown below does that. It uses one set of variables but holds true for all assumptions.
The taxed, Roth and traditional accounts are compared side-by-side, with a difference column reconciling the traditional account to the more easily understood Roth account. The difference column tracks the government’s partial funding and ownership of the account. This model holds true regardless of actual cash flows. The original $250 tax reduction at contribution is considered to be invested alongside the saver’s after-tax savings. Its resulting value fully funds the $1,246 withdrawal tax (calculated at the same rate as at contribution).
The benefit from a Roth account is its permanent sheltering of profits from tax. The traditional account gives all savers an exactly equal $784 benefit from the same factor The withdrawal tax is an allocation of principal between the account’s two funders/owners, not a tax on profits as commonly claimed.
Read the full article here by Chris Reed