Save to Retire: Pre-tax, After-tax or Roth?

Optimal Tax Environment to Save for Retirement

Tax-deferred, tax-free, taxable now, taxable later… What’s an individual saver or retirement plan participant supposed to do?

In other words, considering all of one’s individual facts and circumstances (the “variables”), which individual retirement or savings plan, and/or which employer sponsored retirement plan, offers the preferred (or optimal) tax environment in which to save for retirement.

This analysis considers the following three options:

  • Pre-tax (IRA, 401(k)): pre-tax contributions grow tax-deferred; distributions are subject to applicable tax
  • Taxable (“savings account” or “side fund”): after-tax contributions are taxable based on the nature of the invested asset and extent of time the asset is held
  • Roth (Roth IRA, Roth 401(k)): after-tax contributions grow tax-free; distributions are tax-free 

*This discussion and analysis does not consider nondeductible IRAs or Annuities funded on an after-tax basis

The “variables” considered to determine the optimal tax environment:

  • Marginal Tax Rate (MTR) when contributing impacts amount and tax savings (or tax payable) now
  • MTR when receiving distributions may impact tax later
  • Age impacts how much time over which the assets grow
  • Gender life expectancy impacts the number and amount of payments
  • Rate of Return (ROR) and Taxation on invested assets
  • Payment Method: equal periodic or required minimum distribution
  • Financial Means impacts the amount of the annual contribution, and the total amount desired during retirement
  • Estate taxes due at death and applicable beneficiary deductions (IRD)
  • UNCERTAIN VARIABLE: Future changes in Tax Laws

Marginal Tax Rate (MTR): Pay Uncle Sam Now or Pay Him Later?

For most individuals, the most important factors to consider are generally: 1) the tax rate when one contributes; and 2) the tax rate when one receives distributions. In this context, the tax rate is one’s marginal tax rate (MTR), or the tax rate paid on the last dollars earned in a particular tax year (i.e., the tax rate that applies to one’s highest level of taxable income for the year).

  • One’s current MTR determines the tax saved currently (“now”) on pre-tax contributions, and the tax paid now on after-tax savings or Roth.
  • One’s future MTR determines the tax paid in future years (“later”) on distributions from pre-tax accounts or gains from savings (not subject to long-term capital gains), and the tax saved later on tax-free Roth distributions.

The Roth option is generally beneficial to individuals with a lower MTR when contributing versus a higher MTR when receiving distributions in retirement since the tax paid on contributions is at a lower rate. Conversely, the pre-tax option is generally beneficial to individuals with a higher MTR when contributing versus a lower MTR when receiving distributions in retirement since the tax paid on distributions is at a lower rate. In general, savings accounts are less attractive for conservative investors (more on this topic later).

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Copyright © 2009 Barry R. Milberg   All Rights Reserved

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