October 21, 2012
The Tax Benefits and Revenue Costs of Tax Deferral
Peter J. Brady (Investment Company Institute), The Tax Benefits and Revenue Costs of Tax Deferral:
Key Findings: A deferral of tax is not equivalent to a tax exclusion or a tax deduction. Exclusions and deductions reduce taxes paid in the year taken, but do not affect taxes in any future year. Tax deferrals — such as the deferral of tax on compensation contributed to an employer-provided retirement plan — reduce taxes paid in the year of deferral, but increase taxes paid in the year the income is recognized.
The benefits an individual receives from deferring tax on compensation (and, equivalently, the revenue foregone by the government) cannot be calculated by simply multiplying the amount of compensation deferred by the individual’s marginal tax rate. The simple calculations used to quantify the tax benefits and revenue costs of tax exclusions and tax deductions do not apply to tax deferrals.
As a rough approximation, the benefits of tax deferral are equivalent to facing a zero rate of tax on investment income. The benefits of facing a zero rate on investment income will depend on how much investment income is generated by the deferral and how much tax revenue would otherwise have been generated by that income. Thus, factors that influence the benefits of tax deferral (and, equivalently, the costs to the government in terms of foregone tax revenue) include the rate of return earned on investments, the length of deferral, and — to the extent that investments produce capital gains — the frequency with which capital gains are realized.
The relationship between the benefits of tax deferral and an individual’s marginal tax rate on ordinary income is complex. The benefits of tax deferral (and the revenue costs) do not increase proportionately with the marginal tax rate that applies to compensation. In fact, the benefits can decline as marginal tax rates increase. Further, the magnitude of the tax benefits depends on tax rates other than the marginal tax rate on ordinary income at the time a retirement plan contribution is made. The magnitude also is affected by the marginal tax rate that would apply to investment income generated during the deferral period, and the marginal tax rate on ordinary income at the time assets are distributed.
For a range of investment portfolios and distribution methods, there is little difference in the tax benefits per dollar of deferred compensation among individuals in the top four federal income tax brackets (marginal tax rates of 25%, 28%, 33%, and 35%). As this paper will demonstrate, controlling for age and assuming no change in marginal tax rates over time, the difference in the tax benefits (and the revenue costs) of deferral for an individual in the 25% federal income tax bracket and for an individual in the 35% income tax bracket is typically 3 cents or less per dollar of deferred compensation.
An individual’s age typically will be more important than an individual’s marginal tax rate in determining the tax benefits of deferral. For example, in realistic simulations for a variety of investments, the tax benefits per dollar of deferred compensation are greater for a 45-year-old in the 15 percent federal income tax bracket than for a 60-year-old in the 35% federal income tax bracket.
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