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

Optimal Tax Environment to Save for Retirement (continued)

Compare $10,000 contributions for 5 years to both the Pre-tax 401(k) and the After-tax Roth 401(k), and $2,500 contributions for 5 years to the After-tax Side Fund (the savings account)

1 - 10k Roth 401k Female age 40 15 25 33 MTRThe individual receives more from the Roth IRA if her MTR remains static or increases; however, she does receive less from the Roth account if her MTR decreases to 15%.

What is the outcome if her MTR decreases to 17%?

2 - 10k Roth 401k Female age 40 18 25 33 MTRShe receives more from the Roth IRA if her MTR remains static, increases or decreases. However… If she can contribute the extra $2,500 to a pre-tax account, her MTR when contributing verses her MTR when she receives distributions is key. Then again, if this individual is a highly compensated employee and her 401(k) deferrals are limited to $10,000 (since higher salary deferrals are in jeopardy of being refunded at the end of the year), the Roth effectively permits her to save more for retirement. Therefore, even if her MTR decreased to 15% she’d still have more money at retirement since she effectively saved more money.

What is the outcome if she was 30 years old?

3 - 10k Roth 401k Female age 30 15 25 33 MTR

She receives more from the Roth IRA if her MTR remains static, increases or decreases

What is the outcome if she was 50 years old?

4 - 10k Roth 401k Female age 50 15 25 33 MTR









 

 

 

The individual receives more from the Roth IRA if her MTR remains static or increases; however, she does receive less from the Roth account if her MTR decreases by to 15%.

What is the outcome if the individual was was a male age 40?

5 - 10k Roth 401k Male age 40 15 25 33 MTR









 

 

 

Commentary The examples illustrate that the Roth option is beneficial to individuals with a lower MTR when contributing versus a higher MTR when receiving distributions in retirement, and that the pre-tax option is beneficial to individuals with a higher MTR when contributing versus a lower MTR when receiving distributions in retirement. Therefore, it’s clear that one’s future MTR is a significant variable to consider.

The examples also illustrate that time is a significant factor (the “Magic of Compounding Interest”) for both pre-tax and Roth, and that’s why savings accounts are generally a less attractive alternative; and…  If you’ve maxed out on your pre-tax savings, the examples further illustrate that a Roth option provides a means by which you can save more for retirement (see: Roth Maximizes Retirement Benefits; Roth is Solution for HCEs Limited by Test Failure); however

While others who write on this subject may outline the complex mathematics required to solve this puzzle (for example, if you are “x” years old when you start to save, your MTR changes by “y” percent, you receive distributions starting when you are “z” years old, and you receive the distributions over “yadda yadda” years, then the Roth is preferred, or not)…  After the numbers are crunched every conceivable way, it’s the differential in the rates of return on investments in the Roth environment versus anywhere else that is the most significant factor in this analysis.  If one assumes comparable risk factors attributable to the selected investments, a taxable side fund cannot perform as well as the tax-free Roth, because…  

The Roth’s unique tax-free environment is the only one in which a conservative investor might earn 5.5-6% in a taxable bond versus 4-4.5% in a tax-free bond (assumes the taxable and tax-free bonds have a comparable level of risk); or in which a more aggressive individual can invest in other taxable assets absent any taxes on short or long-term gains.

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Copyright © 2009 Barry R. Milberg   All Rights Reserved

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