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401(k): too much of a good thing?

The nation's most popular savings incentive strategy, the 401(k) investment plan, may eventually punish some households for their prudence, a study released this summer finds.

The study, "Does Saving in a 401(k) Raise Your Lifetime Taxes?" reports that if investments made by moderate-income households do sufficiently well, people can get pushed into a higher tax bracket when they withdraw their money, actually reducing the total amount of money they have to spend over their lifetimes. It was written by Laurence Kotlikoff, a CAS professor and chairman of the economics department, and Jagadeesh Gokhale (GRS'90) and Todd Neumann, economists at the Federal Reserve Bank of Cleveland.

According to the study, a married couple earning $50,000 combined at age 25 will lower the taxes they pay and increase the total money they have to spend if they invest in a 401(k) that returns a steady 4 percent per year and both partners live to be 95. But if the return is 6 percent, their lifetime taxes increase 1.1 percent and their available money falls by 0.4 percent. Larger returns yield even higher taxes and less available money.

"The general notion has been that the 401(k) is a really good deal for all workers, no matter what income level, and we were surprised by the findings," says Kotlikoff, who says he and his fellow researchers discovered the phenomenon by accident using the ESPlanner, a personal finance computer program they created and use to conduct academic studies. "I don't think anyone in the country was really aware of this. Certainly economists were not."

Households with incomes of more than $50,000 are not in danger of losing the benefit of the 401(k) investments because their Social Security benefits are already taxed at the upper limit when they withdraw, Kotlikoff says. Research he now is conducting indicates that under the rules of the 2001 federal tax cut, investing in a 401(k) can be at worst a break-even proposition for households with incomes of less than $35,000, because of new tax credits that apply to investments made by such households.

But for the benefit of other workers, Kotlikoff recommends that employers set up non 401(k) investment plans, modeled after the Roth I.R.A.s, which are not taxed at withdrawal.

Laurence Kotlikoff's recent study, "Does Saving in a 401(k) Raise
Your Lifetime Taxes?" is available at his Web site, http://econ.bu.edu/kotlikoff/.

7 September 2001
Boston University
Office of University Relations