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

Optimal Tax Environment to Save for Retirement (continued)

Compare Pre-tax 401(k) to After-tax Roth 401(k) considering distributions from the Pre-tax 401(k) at: 25% MTR, 15% MTR and 33% MTR   

Age Pre-tax 401(k):
$10k/5 yrs @7%
25% MTR Aft-tax
Distribution
15% MTR Aft-tax
Distribution
33% MTR Aft-tax
Distribution
Roth 401(k):
$7.5k/5 yrs @7%
Tax-free
Distribution
40 $10,350       $7,763  
41 21,425       16,068  
42 33,274       24,956  
43 45,953       34,465  
44 59,520       44,640  
66 $263,698       $197,774  
83 255,942 -19,661 -22,283 -17,564 191,957 -19,661
84 0 -19,661 -22,283 -17,564 0 -19,661
Total   $353,901 $401,088 $316,152   $353,901

This analysis yields that the individual receives the same total distribution from either account if her MTR is static. However… if her future MTR decreases, the pre-tax option is preferable; if her future MTR increases, the Roth option is preferable. Learn more about tax brackets versus tax rates

The numerical results are only one piece of the “optimal tax environment to save for retirement” puzzle. For this individual, it’s significant to learn that her future MTR may determine if the pre-tax or Roth is preferable, but it’s not necessarily conclusive. Perhaps this requires further analysis, for example…

What is the outcome if she contributes $10,000 to the Roth 401(k)?

Compare $10,000 contributions for 5 years to both the Pre-tax 401(k) and the After-tax Roth 401(k) considering distributions from the Pre-tax 401(k) at: 25% MTR, 15% MTR and 33% MTR   

Age Pre-tax 401(k):
$10k/5 yrs @7%
25% MTR Aft-tax
Distribution
15% MTR Aft-tax
Distribution
33% MTR Aft-tax
Distribution
Roth 401(k):
$10k/5 yrs @7%
Tax-free
Distribution
40 $10,350       $10,350  
41 21,425       21,425  
42 33,274       33,274  
43 45,953       45,953  
44 59,520       59,520  
66 $263,698       $263,698  
83 255,942 -19,661 -22,283 -17,564 255,942 -19,661
84 0 -19,661 -22,283 -17,564 0 -19,661
Total   $353,901 $401,088 $316,152   $353,901

This analysis yields that the Roth 401(k) is preferable if her MTR is static, decreases or increase; however… this analysis is flawed.

Comparing outcomes from a $10,000 contribution to both the pre-tax 401(k) and the Roth 401(k) is not sound. Contributing to the Roth 401(k) costs the individual $13,333, not $10,000 since the 25% tax is payable up front Roth 401(k) contribution ($10,000 contribution/1 – 25% (tax rate) = $13,333). Therefore…

A sound analysis also considers distributions from an after-tax savings account, or “side fund,” in which the individual invests the after-tax proceeds ($2,500) of the additional $3,333 that it costs to fund the Roth 401(k) [($13,333 - $10,000) (1-25%) = $2,500]. Confused? Consider the following…

Assume the individual’s annual W-2 income is $13,333, that she’s paid once per year, and she can contribute $10,000 to either pre-tax or Roth 401(k).

   Contribute $10,000 to Roth
   401(k); pay stub indicates: 
bbb  Contribute $10,000 to Pre-tax
 401(k); pay stub indicates: 

Gross Pay:

$13,333 
 
Gross Pay:

$13,333 
Roth 401(k): -10,000   Pre-tax 401(k) -10,000
Pay check before tax: $ 3,333   Pay check before tax: $ 3,333
25% tax on $13,333 -3,333   25% tax on $13,333 -833

Net Pay check

$ 0
 
Net Pay check

$ 2,500

When the analysis considers this information, the outcome may surpise you.

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Copyright © 2009 Barry R. Milberg   All Rights Reserved

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