A Troubling Argument in the Wall Street Journal

March 3, 2015

A report of mine was quoted recently in the Wall Street Journal, and it drew a response from a concerned reader.

The “Notable & Quotable” of Feb. 23, which is from the Tax Foundation’s report “Sources of Personal Income,” correctly points out that middle-class Americans earn substantial capital gain returns from pensions and other retirement accounts. The article doesn’t mention how unfair this is to the middle class. The entire distribution from a retirement plan, including the portion that represents long-term capital gains, is taxed at regular rates which can be as high as 39.6%. This is almost double the 23.8% maximum tax rate on long-term capital gains earned outside of a retirement plan.

I think this point is worth addressing, especially since I have now seen it twice in the WSJ. (It also appears in one of the responses here.)

The letter-writer introduces two true facts, and the apparent difference in rates is indeed an item for concern. But the reason I didn’t “mention how unfair this is to the middle class” is that, well, it isn’t unfair. There are two key components of the pension system – components omitted from this simple comparison of one rate to another – that make it a good deal.

Pensions and IRAs get (1) an appropriate tax deduction for the contribution and (2) appropriate deferral of the tax until the money is withdrawn. Once the money comes out of the pension system and into the hands of the retiree, it’s finally taxed for the first time – exactly once – at ordinary rates.

This system is both fair and elegant.

In contrast, the income treatment outside the retirement system is neither fair nor elegant. It may get a lower rate, but it gets no tax deduction for contribution, and no deferral on dividend income or realized capital gains. In other words, it gets taxed immediately on the principle (at ordinary rates) and further taxed (at lower rates) when dividends are paid out and capital gains are realized.

This awkward multi-part tax system is worse than the treatment of pensions and IRAs. For example, if an American (say, one in the 28% tax bracket) earns $100 in salary and wants to invest it outside of her retirement account, she pays taxes on that $100 and finds herself able to invest only $72. Then she pays a more favorable rate from here on, but she has to pay it immediately on every dividend or capital gain she gets, even if she just plans on reinvesting. If she had instead invested the original $100 within her retirement account, she would pay no immediate tax on that $100 in salary, allowing her to earn returns on the full $100. This is a huge positive: the more money you start with, the more money you can earn. Furthermore, she gets to defer all the taxes on gains or dividends until retirement. Ask an accountant or a financial planner. Give them the choice between the lower rate on one hand, and the deduction and the deferral on the other. They’ll take the latter every single time.

People usually have the option of keeping their money out of retirement savings accounts. They just don’t take it, because the retirement accounts are better. In fact, the main reason people leave some gains outside retirement plans is that contributions are capped.

I voluntarily contribute to my 401(k) plan here at Tax Foundation, because it is in my best interest. I like my deduction and my saving-neutral tax treatment and my single layer of taxation. It’s not a trick. I promise.

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