Save to Retire: Pre-tax, After-tax or Roth?
Optimal Tax Environment to Save for Retirement (continued)
Example: Female, Age 40 earns $100,000; the other variables…
Rate of Return (ROR) and taxation on invested assets:
Savings Account: 60% stocks earn 8% taxed at 15%, 40% tax-free bonds earn 4%; blended ROR: 5.68% after-tax
401(k) Account: 60% stocks earn 8% taxed-deferred, 40% bonds earn 5.5% tax-deferred ; blended ROR: 7% tax-deferred
Roth 401(k) Account: 60% stocks earn 8% tax-free, 40% bonds earn 5.5% tax-free ; blended ROR: 7% tax-free
Age at Retirement, Payment Method, and Period: Age 67 (Social Security Retirement Age), equal periodic payments for 18 years (based on Social Security Mortality)
UNCERTAIN (future tax laws): Consider only a portion of one’s savings, $10,000 for 5 years; “Don’t put all your eggs in one basket”
Where to Save to Retire: Pre-tax, After-tax or Roth?
Pre-tax 401(k): Contribute $10,000/year for 5 years (age 40-44); Distribute 18 equal payments (age 67-84):
| Age | Pre-tax 401(k) Contribution |
Account Value @7% |
After-tax (25% MTR) Distribution |
| 40 | $10,000 | $10,350 | |
| 41 | 10,000 | 21,425 | |
| 42 | 10,000 | 33,274 | |
| 43 | 10,000 | 45,953 | |
| 44 | 10,000 | 59,520 | |
| 45-66 | 0 | $263,698 | |
| 67-83 | 255,942 | -19,661 | |
| 84 | Last Payment | 0 | -19,661 |
| Total | $353,901 |
After-tax Savings:
Calculate contribution after paying tax…
$10,000 x (1- 25% (tax rate)) = $7,500 after-tax; Contribute $7,500/year for 5 years (age 40-44); Distribute 18 equal payments (age 67-84):
| Age | After-tax Contribution |
Account Value @5.68% |
After-tax (0%) Distribution |
| 40 | $7,500 | $7,713 | |
| 41 | 7,500 | 15,864 | |
| 42 | 7,500 | 24,478 | |
| 43 | 7,500 | 33,581 | |
| 44 | 7,500 | 43,201 | |
| 45-66 | 0 | $145,661 | |
| 67-83 | 153,935 | -13,131 | |
| 84 | Last Payment | 0 | -13,131 |
| Total | $236,365 |
Compare Pre-tax 401(k) to After-tax Savings
| Age | Pre-tax 401(k): $10,000 for 5 years @7% |
After-tax Distribution |
After-tax Savings: $7,500 for 5 years @5.68% |
After-tax Distribution |
| 40 | $10,350 | $7,713 | ||
| 41 | 21,425 | 15,864 | ||
| 42 | 33,274 | 24,478 | ||
| 43 | 45,953 | 33,581 | ||
| 44 | 59,520 | 43,201 | ||
| 66 | $263,698 | $145,661 | ||
| 83 | 255,942 | -19,661 | 153,935 | -13,131 |
| 84 | 0 | -19,661 | 0 | -13,131 |
| Total | $353,901 | $236,365 |
A quintessential example of the: “Magic of Compounding Interest” in a pre-tax environment; but…
Is this example sound? Perhaps it fails to consider a key variable…
Copyright © 2009 Barry R. Milberg All Rights Reserved