Contributing to an employer sponsored retirement account, like a 401(k), is automated and easy. The most complicated aspect is picking a plan and then choosing what percentage of your earnings should be deposited each paycheck.
But if you’re looking to take full advantage of retirement investing strategies, or an employer sponsored retirement plan isn’t an option, how do you choose between the various accounts such as a traditional IRA vs. a Roth IRA?
There are tax advantaged accounts including:
- Traditional IRA
- Self directed IRA
And there are after-tax investing accounts including:
- Roth IRA
- Roth 401(k)
Often the main deciding factor in picking an investment strategy comes down to taxes. Namely, how do you maximize investment growth and minimize the taxes you pay.
In this post I run through the math of what it looks like to invest in either a tax-advantaged or an after-tax retirement account in order to understand just which one may be the better investing strategy.
Contents and Quick Links
- 1 What are pre-tax contributions?
- 2 What are after-tax contributions?
- 3 Conventional belief about after-tax contributions
- 4 Money lost by making after-tax contributions
- 5 Tax rate of contributions vs. withdrawals
- 6 When should you contribute to an after-tax retirement account?
- 7 Conclusion
- 8 More from the Money Crunching Mondays Series
What are pre-tax contributions?
First, let’s look at what the difference is between a pre-tax, also called a tax-advantaged, retirement account.
When you invest in a traditional IRA or an employer sponsored retirement account such as a 401(k), the money you contribute is taken from your earnings before it is taxed. This means that the salary you report to the IRS to pay income tax on is lower than the amount you actually earned.
If you earn $100,000 in a year and contribute $15,000 to your 401(k), you only pay income tax on $85,000 of income.
This means that you can effectively lower your tax bracket, simply by saving for retirement.
Using the 2019 federal income tax brackets, if you are single and earn $95,000, you will have an tax rate of 24% and pay $22,800 in income tax.
However, if you contribute $10,800 to your 401(k), your taxable income will be $84,200. This lowers your income tax rate to 22%. You would then owe $18,524 in taxes. That’s a savings of $4,276 in taxes owed and you saved a hefty $10,800 for your retirement.
Note: This is an overly simplified example. The U.S. actually uses a progressive tax system. This means that if you earn $95,000 in income, you are taxed 10% on the first $9,700. Then you are taxed 12% on earnings between $9,701 and $39,475. Next, you pay 22% tax on earning between $39,476 and $84,200. Finally, you pay a 24% tax rate on the remaining $10,800.
2019 Federal Income Tax Brackets
Do you ever have to pay taxes on pre-tax contributions?
The answer is of course, yes. You may save money by making pre-tax contributions to your retirement account, but you will eventually need to pay taxes on it.
Contributions to tax advantaged retirement accounts are made pre-tax and grow tax free. This means that all earnings are free from capital gains taxes, unlike many other investments. However, you pay income tax on the money that you withdraw during retirement.
When you retire and make regular monthly withdrawals from your 401(k), you are taxed as though you were earning an income.
You retire at the age of 65 and start withdrawing $40,000 per year. This full $40,000 is taxed as normal income tax, similar to your W-2 income. If you do this in 2019, your tax rate would be 22%.
Note: Again, due to the progressive tax system, you are really only taxed 22% on $525. The other $39,465 was taxed at the lower rate of 12%.
Withdrawals during retirement are often lower than income earned during working years, which means you will likely remain within a lower tax bracket throughout retirement. This further takes advantage of tax savings by investing in a tax advantaged retirement account.
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What are after-tax contributions?
After-tax contributions are made with income that has already been taxed. Which may leave you asking, why would you do that?
Well, earnings grow tax free and you don’t pay income tax when you withdraw money later.
You invest $5,000 to your Roth IRA every year for 15 years. Then you let it sit for another 10 years. A full 30 years after opening your Roth IRA account, you begin withdrawing funds. Assuming your earnings grew at a conservative interest rate of 7%, your account balance would be over $378,000. (I used a compound interest calculator to figure this out.)
Total contributions: $75,000
This means that you paid tax on the $75,000 you contributed, but you pay nothing on the remaining $300,000 in earnings.
At this point you may be thinking that this is an amazing and powerful way to grow retirement savings and avoid paying taxes.
However, there is no way out of paying taxes. You can only defer them.
Conventional belief about after-tax contributions
If you have $5,000 to invest for retirement, you can contribute to a traditional IRA or 401(k), or, you can contribute it to a Roth IRA.
- $5,000 added to a Roth IRA will not be taxed when you withdraw it later
- $5,000 added to a traditional IRA or 401(k) will be taxed later
With only this information, it is clear that you will end up ahead when you contribute to the Roth IRA, where money grows tax free and is withdrawn tax free.
Or is it??
Money lost by making after-tax contributions
As it actually turns out, there is no way to avoid paying taxes. Now let’s run the numbers to see how you managed the tax savings on $300,000. And whether it was worth it or not.
You fund your Roth IRA with $5,000. You earn $100,000 in taxable income, putting you in the 24% tax bracket.
Your $5,000 contribution required earnings of $6,200, since you paid 24% in income tax.
$6,200 – 24% = $5,000
This is $1,200 that you can’t use to invest and therefore earn even more money.
What could you have done with that 1,200 instead?
If you were to hypothetically invest that $1,200 that you paid in income tax, after 30 years you would have $122,700.
$1,200 per year contribution earning 7% interest for 30 years = $122,700
That’s $122,700 less in your account because you invested in after-tax earnings.
Tax rate of contributions vs. withdrawals
In the debate of pre vs. post-tax contributions, it all comes down to how you are taxed.
Because of the progressive tax system, after-tax contributions to a Roth IRA or Roth 401(k) are taxed at a higher rate. Withdrawals from a traditional IRA or 401(k) are taxed at a lower rate.
This effectively means that you earn more money in a tax-advantaged account and pay less in taxes overall.
Which makes the pre-tax retirement account more appealing.
When should you contribute to an after-tax retirement account?
If tax advantaged accounts are so amazing, even when you pay taxes later when you withdraw money, why would you ever make after-tax contributions to a Roth IRA or Roth 401(k)?
Again, it comes down to tax rates.
If you can expect additional income during retirement from other sources, your overall tax rate in retirement will go up. This levels the playing field between pre and after-tax contributions. It may even tip the scales in favor of the Roth IRA.
Additional sources of income could include:
- Social Security
- Standard taxable investment accounts
- Real estate investment income
- Continuing to work and earn income during retirement
Other reasons (which are beyond the current scope of this article) to continue contributing after-tax dollars to a Roth IRA or Roth 401(k) may include:
- Tax diversification
- Estate planning
- Peace of mind that you won’t pay taxes later
- Flexibility in contributions and withdrawal rules
- Rising inflation and tax rates
Investing in after-tax Roth accounts in a post COVID-19 economy
I’m adding this section in because it may be enough of a concern to alter my personal investing strategy. With quantitative easing (or printing money) in order to stimulate the economy, the deficit continues to build. The long-term result could very well be inflation and increasing tax rates. Two key factors that make Roth accounts more valuable and appealing.
Add to this the very high contribution limits of Roth 401(k) accounts and the flexibility of investing with money from your Roth IRA (purchase of a rental property that wouldn’t be taxed on income and capital gains, ever), there are some very compelling reasons to utilize both types of after-tax retirement accounts, especially if your aim is financial independence or early retirement.
Conventional wisdom would imply that investing in a Roth IRA will save money overall, since contributions grow tax free and withdrawals won’t be taxed later.
However, due to differences in the rate at which contributions are taxed during working years and how withdrawals are taxed during retirement years, a tax advantaged traditional IRA or 401(k) may very likely be the better bet.
While everyone has a unique situation and should of course consult with a professional in determining which is ideal for your personal investment and retirement needs, investing first in pre-tax accounts is likely to save and earn more money overall.
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