You do not save taxes in a qualified plan you defer them. It is not a tax saving plan but a tax deferral plan. You defer the taxes and you defer the future tax calculation. The taxes you defer are really apparent tax savings; you will not be sure until withdrawal. |
If we begin with a $5,000 annual contribution and a 30% tax bracket both currently and at withdrawal over a 30-year period with a return of 5% we will notice the following. Our account balance will be $348,804 of which we receive $244,163 and the government gets $104,641. The apparent taxes deferred are $45,000. The IRS wants the $1,500 of apparent tax savings we received during the years of contribution back at interest. Since we earned 5% on our money the IRS wants their money back at 5% as well and the total comes to $104,641. Should the withdrawal tax bracket increase or decrease our apparent taxes deferred will not change because we are assuming a constant tax bracket during the years of contribution. If the withdrawal tax bracket increases the government will receive a bigger piece of the pie. However the apparent tax benefit we thought we received did not change. If the withdrawal tax bracket is lower then we actually received more tax benefits than we anticipated compared to our bracket at the time of contribution. Remember the key is that not only are you deferring the taxes but you are also deferring the tax calculation. |
This screen emphasizes that qualified plans defer taxes as opposed to saving taxes. The initial or default values set the current tax bracket and the withdrawal tax bracket the same. This is an important and big assumption. Given this assumption and keeping all else the same, the Apparent Taxes Saved at interest will be the same as the final tax due at the end of the time period. Apparent Taxes Saved at interest means that we accumulate the taxes year by year, calculate the annual interest earned on the accumulated balance each year, add it to the balance and the next year repeat the cycle. Given the assumptions that the two tax brackets are equal and all else is the same, this screen is similar to the statement "The whole is equal to the sum of all the parts." Whether we paid part of the taxes each year or all the taxes at the end, the tax paid will be the same if both methods of paying taxes treat the time value of money the same. This screen has nothing to do with the true return on a qualified plan. It is just to emphasize that taxes are deferred as opposed to saved. The rate of return on a qualified plan depends on the current tax bracket over the years of investment and the final tax bracket at withdrawal. |