Not all tax advantages are created equal. There are tax-deductible, tax-deferred, and tax-free plans. Understanding tax-advantaged retirement accounts is essential to make the best decisions for your retirement savings.
This issue is coming up a lot recently due to what seems to be a new norm in financial advice. Individuals signing people up for retirement plans are advocating an equal split between traditional retirement accounts such as 401(k)s and their Roth counterparts. Like most advice given without consideration to your individual situation, it has a high potential to cause harm.
The Magic of Traditional Tax-Advantaged Retirement Accounts
The magic of traditional workplace retirement plans such as the 401(k) comes from several forms of tax advantages. For example, contributions to 401(k) plans are tax deductible. Subject, of course, to generous limitations.
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Tax Deductibility
Absent other benefits, tax deductibility would still be a home run. Consider some simple math: You contribute $2,000 to your 401(k) in a year when your marginal tax rate on these contributed dollars is 25 percent. The contributions come out pre-tax, saving you $500 ($2,000 times 0.25). This is equivalent to a 33 percent return day one. Not a typo. Thirty-three percent day one.
You contributed $1,500 net from your paycheck. The government provided you with $500 in tax savings, yielding you an investment of $2,000 that cost you $1,500 — a 33 percent return. That’s before any contribution from investments.
Just for putting the money into the account using pre-tax dollars, you’re already winning big-time.
Also note that these are modest assumptions. You may have a higher marginal federal tax bracket, and you may have state tax benefits. The average person should be here or higher on day one.
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Matching Contributions
In the corporate world, most companies provide some sort of matching contribution. The most common practice is to match half of the first 6 percent of the income you contribute.
If the above numbers represent your contribution of six percent and your employer matches that with a 50 percent company contribution, you’d be at a total of an 83 percent return on your investment day one (the 33 percent tax advantage, plus the 50 percent match). Sweet.
Keep in mind, though, that if you’re not in the corporate world — or sometimes even if you are — you won’t have matching on your retirement contributions. But these tax-advantaged retirement accounts are still a phenomenal deal.
Tax Deferral
And the gift keeps on giving. You also get tax deferral: Your investments grow tax deferred. In other words, you don’t pay taxes on the gains on an ongoing basis. You will, however, be taxed upon withdrawal. We’re going to come back to this — it’s an essential piece of the decision process.
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The Magic of Roth Retirement Accounts
Roth retirement plans also have a magic of their own. They’re taxation escape artists.
Granted, you don’t get the upfront deductibility, so you lose that leverage of the upfront tax advantage. But you do get ongoing tax deferral. Your gains in the account are not subject to ongoing taxation.
The Roth’s shining moment is when you go to use the funds in retirement. You’ll get tax-free distributions. And there are none of the minimum required distributions that traditional retirement accounts are subject to.
You can withdraw as much or as little as you chose from your Roth without taxation. That’s huge.
Theoretically, the investments’ net of taxes should be exactly equal — and they’re often presented as such. Alas, that just not true. Advisers suggest splitting equally between the two because the net will be the same and it gives you a choice of whether to use the taxable or tax-free dollars.
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Roth vs. Traditional: When Equal Isn’t Equal
Let’s do a simple numerical comparison. Let’s suppose you invest $2,000 per year into a Roth 401(k) from age 25 until age 65 and achieve a 7 percent average annual return. You’ll end up with $459,264 to spend in retirement. And you get to spend that tax-free.
If you put the same out-of-pocket cost into a traditional 401(k), you get to invest more upfront because of that tax advantage we discussed earlier. At a 25 percent marginal tax bracket, you get a 33 percent advantage. You can put $2,666.66 into your traditional 401(k) at a $2,000-per-year out-of-pocket cost. In the same timeframe of age 25 to 66, obtaining the same average annual return of 7 percent, your investment will grow to $612,352. But you need to pay tax on the distributions.
If you paid a tax of 25 percent on the total $612,352, you would be left with exactly the $459,264 you had to spend out of the Roth.
Sure seems equal. But things aren’t always what they seem.
That’s not how taxes work. If the same tax structure that’s in place now is in place during your retirement, you’ll pay far less in taxes on the withdrawals than you saved on the contributions. This is the magic of math.
You deduct your contributions at your marginal rate. The marginal rate is what you pay on the last dollar. If you don’t earn that dollar, you don’t pay that tax. This is the top rate you pay at that time.
When you’re retired and you begin making withdrawals, you fill up lower-rate tax buckets before higher-rate buckets. This also happened when you were working. But the tax you’ll pay will be at these combined rates. You figure your tax on distributions at your effective rate, not your marginal rate.
You also have other factors working to lower your effective rate below what it was while you were working. In our example from earlier, you would likely incur far less than 25 percent tax on your distributions across time, making the pretax 401(k) a clear winner for the average investor.
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Income and Other Factors in Tax-Advantaged Retirement Accounts
Since tax deductibility as a trade-off for taxation later becomes a difference between the relatively higher marginal rate while working and the relatively lower effective rate while retired, income and rates clearly make a difference in the calculations.
Lower-income savers get less of a boost from upfront tax savings, but also might see very little or possibly no tax savings from the Roth plan. While higher-income earners obtain a greater upfront advantage, they would also make greater use of tax-free dollars in retirement.
If you’re going to have too much money in retirement and will simply passing it on, the Roth has some real advantages to your heirs.
Can’t discount that if you’re in that situation.
Another advantage of the tax-deferred plans is behavioral. People tend to be slower to spend dollars they’ll pay taxes on. Given a choice, they’ll blow through any Roth funds in retirement before spending from traditional taxable accounts. Many people can’t afford to blow through anything in retirement, and any impediment to overspending is a good thing.
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Roth vs. Traditional: Pulling Everything Together
The advice to split dollars between the two types of tax-advantaged retirement accounts has no basis in any form of reality. It’s a cop-out for a plan representative who might not understand taxation and wants you to move forward quickly so they can move on to the next person. Or perhaps they just don’t know. But how much — if any — of your retirement account you should invest in a Roth instead of a traditional retirement plan depends on your particular situation. There’s no magic percentage.
Many comparisons of the different kinds of tax-advantaged retirement accounts are false ones. You don’t get to consider whether it’s better to have a million dollars in a Roth or a million in a taxable plan. You give up that day-one return of tax deductibility with the Roth. Your decision is more like, “Are you better off with a million dollars in a Roth retirement account or $1.5 million in a traditional plan?”
I would much rather take the million and a half. I’m pretty damn sure I’ll end up with more spendable money out of the significantly larger account, even after sharing it with Uncle Sam and his state cousins.
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