Should I Keep Contributing to my Pre-Tax Retirement Account Even if I will be in a High Tax Bracket in Retirement?
A high income couple I met with this week asked me this question. Of course, the quick answer from financial advisors is that it is always better to pay tax later, rather than to pay tax now, and we generally assume that people will be in a lower tax bracket in retirement than they are at the peaks of their career. But for individuals who have been diligent savers and have accumulated very large amounts of money in their IRA and 401k accounts, or who expect large payments from defined benefit pension plans, the math might be a little different. Since these accounts must be distributed as taxable income during the saver’s lifetime, large account balances will inevitably result in large taxable incomes in retirement. So is it a good idea to keep plowing money into tax deferred retirement accounts?
I wasn’t sure, so I ran my own spreadsheet analysis to understand how the numbers work. The answer appears to be YES, the pre-tax savings will still win. Consider how the math works.
Lets assume a high income earner in the 35% tax bracket is able to defer $100,000 into a combination of tax deferred vehicles. That entire $100,000 starts to grow at an average 7% per year. In ten years, the account will double in value, and be worth $200,000.
Lets say another investor opts to take the taxable income and invest the after tax proceeds. He nets $65,000 after tax, and invests that $65,000 at 7% (for simplicity lets assume all capital appreciation here – no taxes until the investment is sold). The account will grow to $130,000 in 10 years.
So far, the tax deferred approach is clearly winning. But lets say that at this point the saver is required by law to start taking taxable distributions from the account, even though he really doesn’t need the money for living expense. And lets further assume that he has numerous retirement income sources and so is still in the 35% tax bracket.
Assuming that he now pays the 35% tax on the required distributions, and reinvests the proceeds into an after tax account – the total value of his after tax and pre-tax accounts remain higher than the other investor who paid the tax up front. Why? The power of compounding, that’s why. The larger starting balance in the tax deferred account gives the tax deferred investor such a head start that EVEN THOUGH HE PAYS MUCH MORE TOTAL TAX OVER HIS LIFETIME – HE STILL HAS MORE MONEY IN THE END!
Now there are plenty of reasons savers might want a sizable portion of their savings in after tax investment accounts – but when it comes to accumulation power the pre-tax account wins!
I will gladly share my spreadsheet analysis with anyone who is geeky enough to want to explore this in greater depth!