Pay Tax Now or Later?

One of the biggest stumbling blocks to those considering the purchase of a dividend-paying whole life insurance policy is that the premiums to fund the policy are not tax-deductible. In other words, a policyholder must pay into the policy with “after-tax” dollars. In contrast, popular tax-qualified retirement vehicles, such as a 401(k), effectively allow an employee to contribute “pre-tax” dollars into the plan.

The situation is complex, however, because we are not dealing with one asset being taxed and the other enjoying tax-free status. On the contrary, once money goes into a whole life policy, the internal growth of the policy is not taxed, the growing wealth can be effectively accessed via policy loans with no tax consequences, and the death benefit is ultimately paid with no income tax liability to the beneficiary. (We are speaking here of a whole life policy for which the policyholder has been careful to follow the relevant funding guidelines and not let it become a Modified Endowment Contract, or MEC. Of course someone wanting to learn more on these subtleties should consult with a qualified life insurance professional.)

On the other hand, when an employee is retired and begins drawing out distributions from his or her 401(k), at that point the original contributions plus the accumulated growth are taxed according to the then-current personal income tax code.

Thus we see that either way, individuals must pay income taxes. The question is: When? The tradeoff involved also occurs with other potential vehicles, such as a Roth IRA (in which the original contributions are made with after-tax dollars, but then the growth and distributions are not taxed further).

We have given a much more comprehensive treatment of this tradeoff in the November 2013 issue of the Lara-Murphy Report, which subscribers can look up in the archives. We also have covered this issue in Episode 8 of the Lara-Murphy Show. For the present blog post, I want to make a simple point to help readers begin to think through this tricky subject.

Here is the simple truth to get the ball rolling: IF WE ASSUME THE APPLICABLE MARGINAL INCOME TAX RATE, INVESTMENT GROWTH, AND OTHER VARIABLES WILL BE THE SAME TODAY AND IN THE FUTURE, THEN PAYING TAX NOW VS. LATER IS A COMPLETE WASH.

I’ll demonstrate this result first with generic terms, and then with a specific numerical illustration for those who aren’t fans of algebra.

First, the algebra. Define the following terms:

W = Wages (pre-tax) paid today

PIT = Personal Income Tax rate, which is same today as it will be during future distribution

G = net cumulative growth rate of investments purchased today, at time of future distribution

With these definitions, we can now show what a typical employee will end up with at distribution time, if he first considers a Roth IRA (or whole life policy) and then compares it to the performance of a 401(k).

First Calculation: Contribute to Vehicle With After-Tax Dollars

At distribution, left with: W x (1-PIT) x (1+G)

Second Calculation: Contribute to Vehicle With Pre-Tax Dollars

At distribution, left with: W x (1+G) x (1-PIT)

It should be obvious that the above expressions have the same value.

An Example With Numbers

Now, a numerical illustration. Suppose an employee earns $100,000 in pre-tax wage income, his effective personal income tax rate is 30%, and the cumulative growth in his chosen portfolio until retirement is 100%. Then the following calculations show how much he’ll have at distribution time, with the two approaches. (To keep the calculations simple, I’m assuming he puts everything into his retirement vehicle. Obviously if the two approaches are a wash with all of it, then if he only contributes a portion, it’s still a wash.)

First Calculation: Contribute to Vehicle With After-Tax Dollars

The employee pays 30% income tax on the $100,000, leaving him with $70,000. Then it doubles over the decades until retirement time, when the employee pulls out (without further taxation) the full $140,000.

Second Calculation: Contribute to Vehicle With Pre-Tax Dollars

The employee takes his $100,000 and puts it into his 401(k). Over the decades it doubles to $200,000. Then at distribution time he must pay 30% tax on the $200,000, leaving him with $140,000 take-home.

And thus we see that it is a complete wash; either approach leaves the employee with $140,000 after distribution from the two classes of vehicles.

In conclusion, let me stress that I am here merely helping readers think through the “first pass” of this problem. Naturally, individuals would need to add further complications to the analysis, such as the possibility of tax rates changing, and being in a different income tax bracket after retirement. Nonetheless, it’s important to get started on the right footing, and realize that the mere deferral of income tax per se does not reduce its harm, if it ultimately applies to a larger principal.

Naturally, readers should consult with qualified professionals before making any moves with tax consequences.