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…

Pages: 1 2 3 4 5

Copyright © 2009 Barry R. Milberg   All Rights Reserved

Leave a Comment, Question or Answer

You must be logged in to post a comment.