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Smart Personal Finance 101: Bank for Retirement (Part II)

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By Dr. Gary L. Deel
Faculty Director, Wallace E. Boston School of Business

and Dr. Karin Ford-Torres
Faculty Member, Wallace E. Boston School of Business

This is the second retirement article in an ongoing series on sound tips for financial security and prosperity. These articles are intended to share a general overview of conventional, commonly practiced financial methods from business school faculty members and are in no way intended to influence or impart financial/legal advice or actions to or on behalf of readers. Readers should always consult with an attorney or licensed financial advisor before making any financial decisions.

In the previous article in the Smart Finance 101 series, we discussed the potential benefits of employer-sponsored retirement programs. In this part, we’re going to look at the potential implications of pre-tax versus post-tax retirement investments.

Pre-Tax Retirement Contributions

Pre-tax retirement contributions made through employer-sponsored programs can accrue interest the entire time they are in the plan, and taxes on your contributions aren’t due until you’re ready to take the money in retirement.

Let’s go back to our employer example from the previous article, where you were asked to assume you make $1,000 every week. Now, $1,000 might be your pre-tax compensation, but after income taxes are applied your actual paycheck will likely be far less than $1,000. The average income tax rate in the U.S. is currently 14.6%, so if we assume that to be your rate, then your final net pay would actually be $854.

If you were planning to contribute 5% of your after-tax income to a retirement investment, you would only have $42.70 (5% of $854) to invest per week. But by investing in an employer-sponsored retirement plan, you are allowed to make those contributions pre-tax, which means you get to allocate the full $50 (5% of $1,000) with no taxes taken out.

That’s only a difference of $7.30 per week, which doesn’t seem like a lot. But let’s look at how that difference adds up over time.

If you contributed $42.70 per week (after-tax) for 30 years prior to retirement and you earn a conservative 7% estimated annual interest on your investments, your savings at the end of that period would be about $224,000. But if you contributed $50 per week (pre-tax) for the same amount of time at the same estimated rate of return, you would actually have $26,000 in pre-tax savings. That’s a difference of almost $40,000!

But of course, you’d still have to pay taxes on the pre-tax contributions and on any earnings therefrom. So this is where an important question comes into play: Could there be situations when it might actually be better to pay the taxes upfront through what is called a Roth individual retirement account (IRA), which enables you to enjoy your distributions when you take them in retirement after age 59½ without additional taxes on any earnings?

The answer depends on your ability to contribute after-tax dollars when you contribute money into a Roth IRA. Remember, there are limits to the amount you can contribute. Also, your modified adjusted gross income (MAGI) for Year 2021 has to be under $140,000 to be eligible to contribute to a Roth IRA, or $208,000 for married couples filing taxes jointly.

Roth IRAs and Tax Brackets

The opportunity is that the Roth IRA offers tax-exempt growth that could potentially accumulate from your contributions and earnings over a long period of time. Moreover, if you take your distributions after age 59½, they will be taxed as ordinary income, but based on the tax bracket that you fall in at that time not the bracket you were in when you made the contributions years (or even decades) earlier.

For example, the current 2020 U.S. income tax brackets are as follows:

Now, let’s suppose you’re 35 years old right now, you’re single and you’re currently making $40,000 per year. According to the table above, that means you owe 10% of your first $10,000 or so income dollars in taxes, and then 12% on the next $30,000. But that’s it, your tax rate does not exceed 12%.

But imagine that over the next 30 years, you make some excellent business decisions or get promoted several times, such that by the time you hit 65 years of age, you’re making more than $200,000 a year. If you’re still single, your top tax bracket is now 35%! That’s 23% more than you were paying 30 years ago.

So with pre-tax retirement contributions, you pay no tax upfront, but the tax rate at the end could potentially be a lot more — even enough to largely offset the gains you make from pre-tax investments in the first place.

In our earlier example of investment projections, we estimated that a $50 per week pre-tax contribution would result in $263,000 in total investment accrual after 30 years, while a $42.70 per week Roth (post-tax) contribution would only accrue about $224,000 in total value (assuming 7% interest per year). But what would the actual pocketed returns look like after we factor in taxes?

Well, for starters, the post-tax income would be the full $224,000. But remember, we paid the taxes on those contributions upfront, so as long as we wait until retirement to take withdrawals, we owe no taxes at the end.

However, we will definitely have to pay taxes on the $263,000 pre-tax value. Using our earlier tax bracket example, if our bracket is the same at the time we start taking withdrawals as it was when we made the contributions, then we would owe about 12% on this retirement income — both the original contributions and the earnings accrued over time. So 12% deducted from $263,000 leaves us with about $231,000 in total value. That’s still $7,000 more than the $224,000 we would have had if we’d invested after-tax.

But what if our tax bracket went up? If, at the time of retirement, we’re in the 35% tax bracket we discussed earlier, the math changes drastically — $263,000 less 35% is about $180,000. So here, by investing pre-tax and subjecting our retirement investments to the higher tax bracket we’re in at the time of retirement, we actually pocket about $45,000 less than what we would have made if we had invested after-tax.

Unfortunately, our own income bracket isn’t the only unknown variable in trying to speculate about future investment maturity in tax liability. In the next part of this series, we’ll look at another critical consideration: changing tax laws.

American Public University and American Military University offer academic programs in accounting and finance, which cover important financial discussions in depth. Readers who are considering expanding their knowledge and credentials in this field are encouraged to visit our program pages for more information.

About the Authors

Dr. Gary Deel is a Faculty Director with the Wallace E. Boston School of Business at American Public University. He holds a J.D. in Law and a Ph.D. in Hospitality/Business Management. Gary teaches human resources and employment law classes for American Public University, the University of Central Florida, Colorado State University and others.

Dr. Karin Ford-Torres is an Associate Professor with the Wallace E. Boston School of Business at American Public University. She holds a Ph.D. in Business Administration with a concentration in Advanced Accounting and Financial Management. Karin teaches accounting and finance courses for American Public University, Purdue University Global and Colorado State University-Global. She has 24 years of prior banking experience with Bank of America.

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