Mar 24

For my first post of this year I wrote an article titled, “Can you save too much, pre-tax?” This is a topic that comes up frequently as one decides whether to choose a Traditional (pre-tax) IRA vs a Roth IRA. I recently had some dialog with another blogger and it’s clear to me that the decision is not so clear cut. Ideally, one makes a deposit pre-tax and withdraws it at a lower rate some time later. But as Mark (the other blogger) reminds me, a Roth has many benefits that shouldn’t be ignored:

  1. You can withdraw the original deposits at any time with no tax or penalty, as I suggested in my Roth magic post.
  2. A Roth has no RMDs (required minimum distribution) requirement, which forces withdrawals when they may not be needed or wanted due to other considerations.
  3. The accounts pass through one’s estate with less impact to estate tax as the funds are denser, and received by the beneficiary with no income tax upon withdrawal.

I think for any retiree there is likely an ideal mix, so they might draw funds from their pre-tax accounts (IRA and 401(k)) and use Roth withdrawals to avoid getting sent into the next bracket or be subject to the Social Security Tax Trap. The issue today is that we can’t know that mix two or three years out, let alone 20 or 30. What I do know, and I hope Mark agrees, is that this decision follows the shape of the Laffer Curve. I know with certainty that 100% of one’s savings in pre-tax accounts misses the benefits I share above. 100% in Roth accounts will miss the benefit of the zero bracket I discussed at length in my article cited and linked above. I don’t know the ideal mix, but I’d suggest this: The lower your savings rate, the more you’ll see the benefit of pre-tax savings, a diligent saver may be best served by leaning toward the Roth savings. A Wall Street Journal article titled “A Cool Million No Longer Buys You a Luxe Retirement” helps back up my position as it states that only the richest 2% of Americans have saved more than $1 million. One would need to be in this exclusive group to even begin worrying about higher taxes on the their retirement savings. I hope to get some feedback, as others’ opinions always help me to see a different side of the issue.

Joe

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10 Responses to “Pre Tax vs Post Tax savings”

  1. Scott Says:

    I agree with you and am glad to finally find someone else who posts this information. Most people automatically recommend the Roth over the standard IRA simply because the projected marginal tax rate will be higher at retirement. Many middle classers are already under invested, and I dont think a lot of them are going to have a lot of other income coming in to fill up the 0% bracket (deduction, etc). I know I wont, and I am single making over $60,000/yr. And as far as SS, anyone looking off 20+ years better not count on a whole lot of that, if any. And with so many people behind in investments, they probably aren’t going to have enough IRA income to boost SS into the taxable realm anyway, if they actually get any SS to begin with. I’m sure I could get by with a combined IRA+SS of $32,000/yr during retirement. So with that, 6 or 7% effective tax rate during retirement is much better than the 28% I would have to pay in taxes for the Roth right off the bat. It’s amazing that most financial advisors and websites comparing the two seem to make the asumption that the entire IRA withdrawal will be made at the marginal rate, and deductions are never factored in either. It’s good to see someone out there gets it.
    Suze Orman doesn’t seem to get this either.

    And neither does this guy:
    http://asktheexpert.blogs.money.cnn.com/2008/03/03/timing-uncle-sams-take-from-your-nest-egg/

  2. JOE Says:

    Thank you for writing, Scott. I like the article you referenced, at least it seemed more balanced to me than most. One thing I noted was this: The author suggests that “you cant contribute $20,667 in pre-tax dollars to the regular 401(k) because you would exceed the $15,500 limit.” True, but wanting to put in that much implies an income pushing $100K or more. This is only 16% or so of the the US population. (See http://en.wikipedia.org/wiki/Household_income_in_the_United_States) In general, I’m not writing for those few, but for most people. Most can’t save more than the $15,500 limit (plus the $5000 for the IRA). Too many people people will lose out by following the Roth path before they retire. Funny, the other blogger I referenced replied to me with “I truly believe that Roth IRAs, after that analysis, will likely be the retirement vehicle of choice for 9 out of 10 individuals.” That’s really a shame, as it likely would benefit less than one in ten. Even the $100K earners are not all saving so much to put themselves at risk of jumping to a higher bracket at retirement. This is a topic I’m sure I’ll be visiting again soon.
    Joe

  3. Scott Says:

    Right, I basically ignored his comments about the $15,500 being a limit. Most people can’t even afford to contribute the IRA minimum and are burried in credit card debt.

    The thing that bothers me about that article, like many others, is that he repeatedly hangs on the tax bracket at contribution vs retirement as being the key determining factor as to whether you should invest in traditional vs Roth, and he implies that the withdrawals are taxed at the marginal tax rate. There’s no mention in there that anyone making a withdrawal would get a tax deduction or have to pay into lower tax brackets of a progressive tax scale before paying anything at the marginal rate. Some of the responses indicate that was their take also, such as, “you retire and start taking it out, you have to pay tax on the 25,000. AT 25% thats 6,250.” The author also stated that if you knew your tax bracket at retirement, it would simply be a matter of using the calculator he links to, but I found two problems with that calculator. When doing the direct comparison in the graph of Roth vs Traditional, that calculator assumes that if you have $5000 of gross income to invest, that you can put the same $ into both funds, but we know the Roth investment would be less due to the initial tax that comes out of the $5000. And the bigger problem with the calculator, is just as I was saying about that article, is if you enter 15% as the marginal tax rate in the calculator, it applies that tax rate to the entire final total of the traditional investment, as if deductions and the progressive tax structure didn’t exist, when we know it would likely be a much lower percentage, especially for most people. We don’t know what the future holds, but we can at least apply current facts and trends in our calculations rather than applying the “marginal tax to all” philosophy. Of course, there are other things to consider, primarily if someone is able to invest more heavily, will hit the yearly contribution caps, and will have higher forced distributions during retirement, and whether someone has other sources of income. I dont think that applies to most people, so I agree with you, when it comes down to the pure numbers, and the people most needing advice, the traditional IRA is the better choice.

  4. JOE Says:

    Well, we’re on the same track, Scott.
    I am working on a way to describe the whole trade off a bit better, a chart that can show how and why one type of account is better for a given individual. Mark, the other blogger seems as convinced of his position as I am mine.

    Of course – if one has a huge taxable pension (they still exist) they may retire in the same bracket as when they worked, and any IRA withdrawals would, in fact, be at the marginal rate. But that doesn’t appear to be the case for most. Mark seemed to feel that lower income people should favor Roth, but again, those people are likely to retire with little savings at all, and be in the ‘zero’ bracket.
    I appreciate your thoughts. Thanks for visiting.
    JOE

  5. Augustine Says:

    Gentlemen, for a lay person like me who can afford saving, what would be best, both traditional and Roth to hedge the odds of higher taxation or of high tax rate?

    TIA

  6. JOE Says:

    First see my feature article http://www.joetaxpayer.com/toomuch.html then think about three points: What is your present tax rate? If you continue to save at the current pace, how much will you have at retirement? At retirement, what will your taxable income be?

    You see, while the Roth is a great opportunity for some, for the average person, you should have a certain amount of pre-tax money saved before thinking about Roth.
    Make sense?
    Joe

  7. Roth Vs Traditional Ira Says:

    Guess who said this: “It is your mind that creates this world”. Thanks.

  8. 401k plans Says:

    A refreshing point of view written in a compelling and interesting way. Nice.

  9. JDK Says:

    Add to the mix that often people invest pre-tax through their employer and may not have a large degree of control over their pre-tax investments. My work offers “buckets” which amount to “International”, “Large Cap,” “Small Cap,” and “Bond.” Each of these earn a return that approximates some index, but it may be far short of what you could earn with the ability to actually pick specific mutual funds or stocks. One could truly invest more in a non-employer provided pre-tax fund, but might they might earn lower returns on these deposits, and the return should be a factor. Which is better? 8% return on Pre-Tax returns, or 15% on Post-Tax returns? This is definitely not an easy subject, especially when there is employer contribution matching.

    People should favor higher control of return all else being equal.

  10. JOE Says:

    Jay, I agree, if the funds in the 401(k) aren’t as good as what else you can invest in, whether due to end investment choice or expenses, one should consider limiting deposits to secure the match, if any. It doesn’t need to be a choice of 8% vs 15%. Even a 1-2% difference makes the 401(k) a loser.

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