There are so many ways that Congress dangles the carrot of tax deductions to motivate us toward a certain behavior. For example, to encourage home ownership we are allowed to deduct our mortgage interest, and even get to exclude up to $500,000 of capital gain when we sell it someday.  What a gift!  Or to encourage charitable giving, we are allowed to take a tax deduction for that benevolent action.

Perhaps the biggest carrot of all is the tax deduction we are given to incentivize us to save into our 401(k) retirement accounts.  And it’s big too – up to $22,500 for 2023 ($30k if age 50+). Saving for retirement is important, so that tax deduction is an easy one to accept and enjoy.  But this carrot has a big proverbial stick waiting to whack you when you retire someday, and that part doesn’t get talked about much. 

In exchange for the carrot of tax-deduction, the “stick” is that you’ve agreed to give a portion of the account balance to the IRS in deferred taxes. As the account grows, their piece grows right along with it. Using a 25% tax rate example, if your 401k is worth $200,000, you really only have $150,000 to spend in retirement because $50,000 of it belongs to the IRS as taxes upon withdrawal.  If that account grows to $1 million, the IRS’s piece has grown to $250,000.  And there’s NO escaping it – your heirs pay the tax if you never do.

But here’s the real heartburn:  Congress gets to dictate how much of your 401k they keep in the form of taxes on your withdrawals. It’s a moving target over which you have no control.  You end up accepting a tax deduction at today’s rates, inherently giving them permission to own however much of your account they need, in the form of higher tax rates.  If you’re keeping an eye on the national debt and the increasing fragility of SS and Medicare as more and more baby boomers retire, it seems inevitable that taxes will go up.

So what’s the solution?  Playing the long game and forgoing the tax-deductible carrot in exchange for growing a tax-free Roth 401k or IRA.  You’ll forever own 100% of your account and be forever immune to future tax increases. If you’ve already built a sizable pre-tax 401k, look to systematic Roth conversions as a way to lessen Uncle Sam’s slice of your 401(k) pie.  You’ll control your financial future – and that makes for a confident retirement.