Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches 11th Edition by Everett Allen,Joseph Melone,Jerry Rosenbloom,Dennis Mahoney

Exercise 3

For several years it has been argued that one of the primary advantages of a pension plan for employees is that it allows them to avoid taxation on a portion of their total compensation during the time they are in a high tax bracket and postpone the receipt- and consequently the taxation- of this money until after they retire. If, as was usually the case prior to the Tax Reform Act of 1986, the employee expected to be in a lower tax bracket after retirement, the tax savings inherent in this deferral could be substantial. However, if the federal income tax system evolved into a modified form of a flat tax system in which many taxpayers expected to be taxed at the same rate, regardless of when their money was received, does this necessarily imply that the tax advantages of private pension plans have ceased to be an important advantage for employees (Hint: Even if all money received from a pension plan is taxed at the same rate, does the fact that money can accumulate at a before-tax rate of return, instead of an after-tax rate of return, affect the eventual amount of money received by the employee )
Although the point made in this question can be demonstrated in several ways, for simplicity assume there is one flat tax rate, no deductions, and all employees participate in defined contribution plans. This allows the question to be restated as follows: given a choice, should an employee elect to receive an extra dollar of compensation in the form of taxable wages and invested at an after-tax rate of return or defer it in the form of a pension contribution that is not currently taxable and receives a before-tax rate of return even though the entire amount will be taxable when distributed in the form of retirement benefits