Tax shelter or trap?

Contributing to 401(k) and similar tax-deferred retirement accounts such as the government's Thrift Savings Plan (TSP) certainly lowers current taxes. But does it lower your lifetime taxes?

If everyone paid the same tax rate, the answer would be an unambiguous yes. But tax rates may be higher when TSP withdrawals occur — either because you move into a higher marginal federal and state tax bracket, or because the government raises tax rates.

In addition, lowering your tax bracket when you're young, at the price of moving into a higher tax bracket when you're older, may reduce the value of your mortgage deductions. And shifting taxable income from your youth to your old age can substantially increase the share of your Social Security benefits subject to federal income taxation.

These ideas come from two researchers at the Federal Reserve Bank of Cleveland and a professor at Boston University. They wrote in a recent paper that participating fully in the TSP appears to raise, rather than lower, the lifetime tax payments of most workers, particularly those with low and moderate incomes.

Contrary to the prevailing view that feds should contribute as much as possible to the TSP, the authors say that because of the way the government taxes Social Security benefits, many feds should consider limiting the money they stash in tax-deferred programs.

The two researchers found that a couple that earns $50,000 and realizes a 6 percent return on their investments wound up paying 1.1 percent higher taxes and suffered a 0.4 percent reduction in spending over their lifetimes by fully participating in a deferred contribution plan such as the TSP.

By participating in a 401(k) plan or the TSP, middle- and low-income households found themselves in higher tax brackets once they retired and had more of their Social Security benefits subject to taxation.

The authors added an important caveat: employer-matching contributions, such as the government's matching of TSP contributions for employees in the Federal Employees Retirement System, more than make up for the increase in the lifetime taxes they computed. But for those in the Civil Service Retirement System, there is no government match.

Given the uncertainty over future tax rates, this study is certainly food for thought, but that's about all. The 1.1 percent tax increase is so minuscule that it's not worth worrying about. And the study didn't take into account the effects of the recent Bush tax cut.

My advice? If you're in FERS, you should continue contributing to get the full employers' match. But once you've gotten it, you may want to invest additional money in a Roth Individual Retirement Account, rather than the TSP, because Roth IRA withdrawals aren't taxed. If you're in CSRS, the case for making Roth IRA contributions is even stronger because there is no government match for your TSP contributions.

Zall is a retired federal employee who since 1987 has written the Bureaucratus column for Federal Computer Week. He can be reached at miltzall@starpower.net.