RothConversion.org

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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