Retirement for most people is the biggest aspect in life that they invest towards. However, it is difficult to know whether you should invest in pre-tax or after-tax 401(k).
Employers try to pull in top talent by offering matches on employee contributions in retirement plans like a 401(k) plan. Others offer profit sharing plans or employee stock plans (ESOP). These options provide incentives to employees. Because of this, they have opportunity for growth and profitability.
Pre-Tax 401(k) Investment
Those incentives are great. However, all that money ends up being invested Pre-Tax into those plans. This means that when you take the money out in retirement, you have pay the taxes. The taxes aren’t just on the contributions. They’re on everything. Both the contributions and the growth of those contributions are subject to taxes, when they are withdrawn. The IRS (aka: the man) will say, “that’s okay because you’ll be in a lower tax bracket typically in retirement because you’re no longer working.” Let’s see how that works out in real life with an example.
Taxable Contributions
Let’s make an example of Average Joe. He is 38 years old and makes $70k/year. This is about double the median personal income in the US. His company offers a 5% match dollar for dollar. If he puts in at least 5% ($3,500) of his salary, the company will match his 5%. That’s a total of 10% ($7k) for the year.
The $3,500, if invested in the pre-tax part of the 401k plan, lowers his taxable income from $70,000 to $66,500. As a result, this saves him about $800 in taxes for that year. That figure was calculated by using 22% as his tax rate and rounding up.
Now, say that $3,500 he contributed grows for 30 years at 8% rate of return. That money grows to $35k pre-tax. When he takes that money out, he will have to pay the tax on the everything. Not to mention Average Joe likely participated more than just that one year. If he withdrew that $35k at 68 years old – assuming the current tax rate of 12% and he’s not taking social income – he would owe $4,200 in taxes.
After-Tax 401(k) Investing
There is one way Average Joe could have avoided that hefty tax bill at age 68. If he invested that $3,500 contribution into the Roth (after-tax) 401k portion of the plan vs the Pre-Tax 401k portion of the plan, when he was 38. Most 401k plans now give the option for employees to contribute money toward a Roth IRA option within a plan. The match or profit share is still going to be pre-tax because the company gets to deduct that as an expense just like the income they pay you.
Roth IRA
The benefits are even more dramatic the longer the money is invested. So, if you’re in your 20s, contributing toward the Roth IRA vs Pre-tax portion of the 401(k) is an option you should strongly consider. Even if you’re in you 50s or 60s, putting money in the Roth portion of the plan may make more sense. This is because you likely have a large amount already in a pre-tax retirement plan, like a 401(k) or Traditional IRA.
Pre-Tax Contributions vs Roth Contributions
Of course, for higher income earners, there are more benefits to the pre-tax contributions vs Roth contributions. However, that all depends if that persons taxable income is going to drop dramatically in retirement. Everyone’s financial situation is different. There are many variables that need to be considered when making this decision. Factors include age, current income, future income, investment time horizon and marriage status.
Contact me today to make sure you are investing towards retirement the right way.