In Part 1, we put forth an example of the full equation of saving for retirement with our example couple, Ryan and Jen. We saw that all the tax-savings they achieved by saving for retirement in a pre-tax manner (through a 401K) are paid back to the IRS every three years or so in retirement.
Now, let’s look at a different scenario to show just how similar the end results are regardless of time horizon, amount being invested, rate of return, etc. As before, this is a simplified scenario using straight dollars (not inflation adjusted) to illustrate the principle. Remember, everything is proportional and designed to benefit the IRS.
Example 2: Max and Trisha
- Time horizon until retirement: 20 years
- Annual amount to save: $16,000 pre-tax
- Vehicle: 401K
- Combined federal and state tax-bracket: 25%
- Assumed annual rate of return: 8%
Since we took the time in Part 1 to break down the example step-by-step, we’re going to move a bit faster now. Pre-retirement Snapshot
- Annual $16,000 pre-tax deposit produces a “tax-savings” of $4,000 per year ($16,000 X 25% tax-bracket = $4,000)
- Over 20 years, total tax-savings is $80,000
- Retirement nest-egg grows to ~$800,000 at 8% rate of return (after 20 years and a month, essentially)
As before, let’s assume that Max and Trisha can earn 8% per year during retirement on their nest-egg, and that taxes magically don’t rise (for example’s sake), leaving them at their combined 25% bracket.
- 401K nest-egg value: $800,000
- Gross retirement income from 401K: $64,000
- Taxes owed: $16,000 (25% tax-bracket)
- Net retirement income: $48,000
- Social Security Income: 85% taxable (thanks to the 401K income qualifying as Provisional Income)
- Max and Trisha’s annual tax-savings due to pre-tax deposits: $4,000
- Annual amount they repay the IRS: $16,000 (400% return to the IRS), not including the extra taxes on their SSI caused by the 401K
- Max and Trisha’s total tax-savings over 20 years: $80,000
- Number of years to pay pack all 20 years of tax-savings ($80,000): 5
- Total taxes paid over 20-year retirement: $320,000
- Total taxes paid over 30-year retirement: $480,000
- Additional taxes the IRS gained above tax-savings they provided: $240,000-400,000
- Approximate amount of taxes owed by heirs ($800,000 401K nest-egg passed on): perhaps 20-35%, depending on how they take it and their tax-brackets. Regardless, taxes are still owed on the 401K nest-egg. That means another 160,000-280,000 in taxes. Now the IRS stands to collect a total of $480,000-$760,000 by virtue of the $80,000 investment (the pre-tax tax-savings) they made in Max and Trisha. That’s $400,000-680,000 more that the tax-savings they granted Max and Trisha from their pre-tax retirement deposits.
No matter what the pre-retirement numbers are, we almost always find that the time period to payback the IRS is around 3-6 years (using reasonable assumptions). Let’s look at one more scenario in Part 3 before we look at a potential solution in Part 4.
Read on to Part 3.