Last year's tax cuts convinced some that retirement accounts no longer matter. That's absolute nonsense.

MAJOR CHANGES IN the tax law almost always spawn misbegotten new strategies. The most misbegotten I've heard in a while is this: Reduced individual federal income-tax rates (from last year's legislation) have rendered your tax-deferred retirement account obsolete.

What makes this theory dangerous is that it actually seems to make sense on first blush. On second blush, of course, it doesn't. In the interest of being totally fair and balanced, I'll explain the anti-retirement-account position before explaining why it's dead wrong.

The Anti-Retirement-Account Manifesto
Write-offs for your retirement account contributions are now worth less than before because of lower tax rates. True. In addition, dividends and long-term capital gains earned inside a tax-deferred retirement account don't qualify for the current 15% maximum federal rate or the even-lower 5% rate on dividends and long-term gains that would otherwise fall within the 10% or 15% rate brackets. Also true. Instead, dividends and gains that accumulate inside your tax-deferred retirement account will eventually be taxed at your regular federal income-tax rate when you take withdrawals from the account. Your regular rate on those withdrawals could be as high as 35%. This is all true.

Therefore, according to the anti-retirement account forces, the new-and-improved strategy is to save for retirement by plowing money into taxable brokerage firm accounts and then investing in equities (common stocks and stock mutual funds). That way, you would reap the tax-saving benefits of the ultra-low 15% or 5% rates on dividends and long-term gains. Since your tax-deferred retirement account is now an outmoded relic of the past, you would be smart to cease making deductible retirement account contributions right now and get with the new program.

The Pro-Retirement-Account Response
The only thing wrong with the new program is it doesn't actually work! Even after all the recent tax-rate reductions, you're still virtually certain to come out ahead by continuing with the traditional approach of making deductible contributions to your tax-deferred retirement account. I realize this is very boring, but facts are facts.

Please don't take my word for it. The numbers tell the story. To generate those numbers, I had to make some assumptions. Here they are.

  • Over the long haul, I assumed equity investments will return 9% annually before taxes. Of that, I assumed 6% will be in the form of long-term capital gains reaped after holding the shares for exactly one year and a day. The remaining 3% will be from dividends. So if you choose to hold equities in a taxable account, my calculations assume the entire 9% return will be taxed at the current 15% maximum federal rate (a historically low rate).

  • You're 25 years away from retirement. My numbers assume that over the next 25 years, your combined federal and state marginal tax rate on ordinary income will be 33% (28% federal + 5% state).

  • Until your retirement in 25 years, your combined marginal tax rate on long-term capital gains and dividends is assumed to be only 20% (15% federal + 5% state).

  • At retirement age in 25 years, your combined marginal income-tax rate on ordinary income is assumed to be 28% (25% federal + 3% state).

    Now for the big questions. Using these assumptions (which, by the way, are skewed in favor of the anti-retirement-account argument), would you be better off making a deductible $10,000 contribution to your tax-deferred retirement account (the "Old Strategy")? Or should you instead invest the same $10,000 for retirement in a taxable account (the "New Strategy")? Here's what the numbers show.

    Outcome Under Old Strategy (Continue With Tax-Deferred Retirement Account Contributions):

    After 25 years, your $10,000 retirement account contribution will grow to an after-tax figure of $62,086 ($10,000 invested for 25 years at 9% with 28% of the resulting balance lost to retirement-age taxes).

    There's more. I also assume you've invested your $3,300 worth of tax savings (33% x $10,000) in a taxable account. After 25 years, that $3,300 will grow to an after-tax figure of $18,767 ($3,300 invested for 25 years at after-tax return of 7.20% (.80 x 9%)).

    So you would accumulate a total of $80,853 ($62,086 + $18,767) after paying all your taxes. Remember: This hefty sum is from just one year's contribution plus compounded earnings over 25 years.

    Outcome Under New Strategy (Invest For Retirement Using Taxable Account):

    Under the new anti-retirement-account strategy, your $10,000 investment in the taxable account will grow to an after-tax figure of only $56,868 ($10,000 invested for 25 years at after-tax return of 7.20% (.80 x 9%). Once again, remember this accumulation is from just one year's worth of retirement savings plus compounded earnings over 25 years.

    And the Winner Is...the Old Strategy (Big Surprise)
    Under the assumptions I've used, you would come out a whopping $23,985 ahead ($80,853 versus $56,868) by making a deductible retirement account contribution and investing the resulting tax savings in a taxable account. That's a little over 42% more retirement-age cash from following the boring Old Strategy than from following the fresh but foolish New Strategy. Another variation of the Old Strategy is to use your annual tax savings to pay for bigger retirement account contributions each year (in other words, your tax savings can actually finance part of your retirement account payins). Either way, you should come out comfortably in front of those misguided souls who follow the New Strategy.

    Of course, following the Old Strategy will put you even further ahead if the tax rates on dividends and long-term capital gains go back up again in the future. I think higher rates are a distinct possibility for two reasons: (1) the current low rates are scheduled to sunset after 2008 and (2) something eventually must be done about the ballooning federal deficit.

    Despite what some may say, last year's federal income-tax rate cuts did not change the traditional wisdom of contributing to your tax-deferred retirement account until it hurts. I've run the numbers, and found this conclusion applies under almost any plausible set of assumptions (for instance, see the sidebar below). Bottom line: the Old Strategy still works best, which makes Old Schoolers like me feel good.

    Contributing to Tax-Deferred Retirement Account and Investing Tax Savings (Old Strategy) Beats Using Taxable Account for Retirement Savings (New Strategy)
    Case Study A
    Tax-Rate Assumptions Old Strategy New Strategy
    33% combined ordinary rate now; 20% rate on LTCGs and dividends. $10,000 $10,000
    28% combined ordinary rate at retirement age in 25 years. grows to:
    $80,853
    grows to:
    $56,868
    Outcome: Old Strategy wins by $23,985.
    Case Study B
    Tax-Rate Assumptions Old Strategy New Strategy
    40% combined ordinary rate now; 20% rate on LTCGs and dividends. $10,000 $10,000
    33% combined ordinary rate at retirement age in 25 years. grows to:
    $80,522
    grows to:
    $56,868
    Outcome: Old Strategy wins by $23,654.
    Case Study C
    Tax-Rate Assumptions Old Strategy New Strategy
    18% combined ordinary rate now; 8% rate on LTCGs and dividends. $10,000 $10,000
    20% combined ordinary rate at retirement age in 25 years. grows to:
    $82,137
    grows to:
    $73,064
    Outcome: Old Strategy wins by $9,073.
    Bottom Line: These numbers show that you would be smart to continue the Old Strategy of making annual deductible contributions to your tax-deferred retirement account and then adding to your wealth by investing the resulting tax savings in a taxable account. Alternatively, you could use your annual tax savings to finance larger retirement account contributions each year. Either way, you'll almost certainly come out ahead.