As a tax professional, I’m often asked by clients whether they should contribute to an IRA or 401k on a pre-tax basis, or after tax. In other words, when putting money in a retirement account now, should they take the tax deduction now for the contribution (i.e. a “pre-tax” contribution), and pay tax when they withdraw the money later? Or should they forgo the deduction now so that withdrawing the money later is completely tax-free?
Of course every situation is unique, so the answer depends on each client’s unique situation. And I nearly always recommend some amount of diversification over time. (I.e. it’s rarely a good idea to put ALL retirement funds in either a pre-tax or post-tax account.)
But I do generally recommend that people put the large majority of their funds into a pre-tax account and take the deduction now.
This sometimes surprises people who don’t think of themselves as making a whole lot of money right now. Or it surprises people who’ve heard from a financial adviser, or a friend, or somebody else who thinks that Roth IRAs and Roth 401ks (the name for after tax accounts) are the greatest thing since sliced bread. (There’s a great example of this thinking in this article, which seems to say anybody who’s not contributing to a Roth 401k is a fool, and your taxes will almost certainly go up in retirement…which as I’m about to show is usually not a good assumption.)
But the reason for my advice is based largely on a fact that most people don’t think about. By and large, when you put money into a retirement account, you’re getting a deduction at your marginal tax rate. But when you withdraw money from a retirement account, you’re typically paying tax on the withdrawals at close to your effective tax rate. OK, there’s a lot to explain in those two sentences, so bear with me.
Let’s say you have $10,000 to put in a retirement account. You can invest the money in an asset that will return ten times the original investment over 30 years. If you have a choice between paying a 20% tax on the money now, or 20% later, the results will be the same regardless. Pay 20% tax now, and the remaining $8,000 becomes $80,000 over time. Or pay no tax now, the $10,000 grows to $100,000, and you’re left with $80,000 after paying a 20% tax. The main variable in this equation is whether you’ll pay a higher rate of tax now or later. You should pay the tax when you get the lowest rate in order to have the most left over after paying the tax.
And that’s where the marginal tax rate vs. effective tax rate comes in. Your marginal tax rate is the top tax bracket you fall in…it’s what you pay on an additional dollar of income. A single person with no exemptions taking the standard deduction and earning $60,000 is in the 25% tax bracket, for example.
Your effective tax rate, however, is basically the average tax rate you pay on all of your income. So that single person with no exemptions making $60,000 will pay a little under $7,000 in tax, for an effective tax rate of a little over 11%. This is because the single person doesn’t pay tax on some income (because of the standard deduction and exemptions), pays tax at 10% on some income, 15% on other income, etc.
And because everybody benefits from some deductions, as well as graduated income tax brackets where they pay lower tax on some of their income, nearly everybody’s effective tax rate will be lower than their marginal tax rate.
So back to the example of the single person making $60,000, this person cuts their tax bill by 25% of any amount put into a pre-tax retirement account. Put another way, if this person has $10,000 to put in a retirement account, then choosing to contribute to this account on an after-tax basis will leave only $7,500 left to put in the account. Over time, that will grow to $75,000.
But if this person contributes to a pre-tax account, leaving all $10,000 to go into the account, that amount will grow to $100,000. But tax will have to be paid as the money is withdrawn. Let’s assume this person has set aside money so that they’ll withdraw $60,000 per year in retirement, and they have no other significant income. In this case, the tax rate when the money is withdrawn will average only about 11%, leaving nearly $90,000 out of the $100,000 — a much better outcome than having only $75,000 left.
Of course, I’ve ignored the effects of inflation, but tax brackets and other items tend to rise with inflation, so this really doesn’t change the fundamental idea. Also, I’m assuming tax rates will remain the same, and of course nobody knows what tax rates will do in the future. However, tax rates will have to change by a pretty huge amount for the effective rate to go from 11% to 25%. And unless that happens, this hypothetical individual is much better off taking the deduction now. I’ve also ignored Social Security income, which makes things a bit more complicated, but for most people Social Security doesn’t change the dynamic very much.
And of course, all this assumes a person’s income doesn’t go down at all in retirement, which is rarely the case. If income goes down, this further tilts the balance in favor of taking the deduction now.
So in my mind, it’s clear that it’s generally more advantageous to take the deduction now for most retirement account contributions. However, there’s an alternative scenario that I’ll look at next time where it’s not quite as clear cut…though as we’ll see it still tends to favor (though not by as much) contributing more money on a pre-tax basis than on an after-tax basis.