The 401(k) plan has evolved into the primary retirement savings vehicle for many American workers over the last 35 years. Participants in 401(k) and similar employer-sponsored plans receive several benefits, including tax-deferral on the assets in their retirement account.
Tax experts subscribe widely to the belief that the longer we can wait to pay a dollar of tax liability, the better. While circumstances vary and every situation should be evaluated on its own merits, this generalization is backed up by the numbers in many scenarios.
A saver who has the choice to fund her retirement account with either pre-tax or after-tax dollars should consider which approach will provide the most spendable income (i.e. after paying taxes on withdrawals) available for retirement living. All things being equal, a worker expecting to be in a lower tax bracket in retirement will keep a higher portion of every pre-tax dollar invested versus investing with after-tax dollars. But as the following example shows, the advantage of pre-tax investing is not dependent on retiring to a lower tax bracket:
John has $6,000 available from his annual earnings before taxes to invest over the next 30 years. His marginal income tax rate is 20%. He will earn annual investment returns of 6.0% before taxes. Invested in a pre-tax account, John will accumulate $502,810 over 30 years. In a taxable account, John will accumulate only $322,960. Why the difference?
First, utilizing a pre-tax account allows all $6,000 to be invested each year. In an after-tax account, John will only have $4,800 available to invest after paying taxes on that income. Once invested in the after-tax account, John will have to pay 20% taxes on the 6.0% return, leaving him with a net return of just 4.8%.
After 30 years of saving in a pre-tax account, if John decides to take a lump-sum withdrawal he will have to pay taxes on the entire sum. In contrast, no taxes would be due upon withdrawal from the after-tax account since all taxes were paid as accrued over the accumulation period. After paying taxes of 20% on his accumulated sum of $502,810, John still has a nest egg of $420,248 – nearly 25% more than in an after-tax account.
Pre-tax investing reduces taxable income in the year it is earned, deferring it into the future. Taxes on investment gains and income are also pushed out into the future, allowing the full return to compound in the account over time. An additional benefit to deferring taxes into the future derives from the impact of inflation – the taxes that are eventually due are paid with devalued dollars.
Retirement savers may have the ability to choose between pre-tax vehicles such as 401(k) and similar plans, traditional IRAs which may allow for tax-deductible contributions and tax-deferred earnings, with current income tax due at withdrawal and Roth IRAs which are funded with after-tax contributions and offer tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. A number of factors impact which approach is optimal for a given investor; your financial advisor and tax professional can guide you in making the decision that is right for you.
The hypothetical example above is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.
Investing involves risk including loss of principal. No strategy assures success or protects against loss.
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