Pre-Tax vs Roth: Save On Taxes Today Or In Retirement?
Saving on your taxes is a priority for almost every person I meet with. I mean, who actually wants to give Uncle Sam more of their hard earned money? So, I often find people are wanting to contribute to a pre-tax retirement account (think 401(k) or IRA) so they can get a break on their current year’s taxes. Plus if you invest that money, you have a chance of it growing to something much larger than your contribution, so it “feels” good, right? What feels good now, may not actually have you feeling good in the long run. So, let’s discuss taxes as it relates to retirement savings and retirement withdrawals in the two primary buckets of money.
Pre-Tax IRA and 401(k)
This bucket of money is also known as qualified money or qualified accounts. It allows “favorable” tax treatment on your income by allowing you to put some of it in a specific kind of account where federal income taxes are not due on it in the year you contribute. If you make $100,000 and you contribute $10,000 to your pre-tax 401(k), you avoid paying federal income tax on that $10,000 for the current tax year.
Let’s say you contribute that same $10,000 every year for 30 years and it grows at 8%. You’d have $1,132,832 at the end of that period. So, $300,000 of that is money you put in and $832,832 is growth from your investments. Not bad!
However, you actually have much less that’s yours. Remember, in this example, you chose not to pay the government when your money went in the account, but only when you took it out. So every withdrawal you take in retirement will be treated as ordinary income (like you were still working).
Just for fun, let’s say you wanted to take the whole amount out at once and you’re married filing jointly. Roughly 30% of your account actually belongs to Uncle Sam. That means you’re left with about $793,000. Ouch.
But Jarrod, you say! I’d never take out that much all at once. True. In fact diligent savers often try to avoid touching this money for as long as possible. Maybe your outside savings accounts, social security, or pension fund your living expenses just fine and you don’t withdraw anything for a long time. That “feels” good too! Except, you have something called Required Minimum Distributions. Somewhere between the ages of 72 and 75, you’ll be forced to take money out of this kind of account. Why? Because the government wants theirs and they’ve been patient for a long time. There is a whole equation that goes into this, but essentially this means more of your money has to be counted as income. This adds on top of what you are already receiving elsewhere and can easily push you into higher tax brackets in retirement. In fact, some people are pushed into higher tax brackets in retirement than they were in their working years! Everyone’s situation is unique, but this is not an uncommon situation with retirees.
Roth IRA and 401(k)
On January 1, 1998, some things changed in the retirement savings world. Senator Roth of Montana came up with the idea of letting people pay taxes on their retirement savings as it went into the account and nothing when it came out. In other words, the Roth IRA or 401(k) has you pay income taxes at your current year’s rate as it goes into your account, then it grows tax free, and withdrawals tax free in retirement.
Using the same example as above, $10,000 still goes in for 30 years at 8% and you have the same amount, $1,132,832. You paid income tax on that $10,000 before it went into the Roth vs the pre-tax option the delayed paying it.
However, in retirement, you can take money from this account as needed and you won’t pay income tax on it because you’ve already paid your share. That means all $1,132,832 is yours! Furthermore, your required minimum distributions are not required for this kind of money, so withdrawals from this account don’t push you into a higher tax bracket.
What’s the catch? Again, you pay at your current year’s income tax rate when the money goes into the account.
Which one do you choose?
This really depends on your specific situation and you should 100% talk with an advisor and your CPA before making a decision. The following is not advice specific to you, but general in nature. The standard rule is if you’re in a low income tax bracket today and will be in a higher one in retirement, you may want to go with Roth. If you’re in a high income bracket today and will be in a lower one in retirement, you may want to go with pretax.
While you’re trying to manage your income, and you may be able to do that to some extent, the other part of this equation is what will the government do with tax rates? Your guess is as good as mine. If you think they are going to go up by the time you retire, then paying taxes now may be a better deal. If you think they are going to go down in retirement, then paying them later may be a better deal.
The fun math part of this is that if tax rates hold the same and your income holds the same, then it mathematically doesn’t matter which one you choose. You’ll have the same amount of after tax money either way. But I think we all know that this is highly highly unlikely to be the case.
Everyone’s financial situation is different. That’s why we call it personal financial planning. So you should certainly talk with someone who will deep dive into your specific situation and give you advice that’s best for you. Finally, there is another opportunity that you may want to consider, especially early on in retirement: the Roth conversion. I’ll discuss this topic more in next month’s post and how you may be able to lower your lifetime tax bill with this method.
Feel free to schedule a meeting or give me a call if you want to discuss your scenario and which may be best for you!
