If the first 3 parts of this post disturbed you, we get it. So, what should we do?
What if Ryan and Jen decided to forgo the upfront "tax-savings" (or, forgo creating a tax tumor) by using an after-tax retirement vehicle, like a Roth IRA, Roth 401K, or LIRP? While these are funded with after-tax proceeds, the earnings they potentially produce are truly tax-free (as long as we follow a few simple rules).
So, their new scenario might look like this:
- Time horizon until retirement: 35 years
- Combined federal and state tax-bracket: 33%
- Annual amount to save: $4,000 ($6,000 before taxes, $4,000 after tax in a 33% tax-bracket)
- Vehicle: Roth IRA/Roth 401K/LIRP
- Assumed annual rate of return: 7.5%
- Annual tax-savings: $0
So, Ryan and Jen are sacrificing the $2,000/yr in tax-savings that they got in the first example in Part 1. Without the pre-tax treatment of their annual $6,000 contribution, they must pay taxes on that amount, leaving them with a net of $4,000 to put away for the future.
- Tax-free Roth/LIRP nest-egg size: ~$667,000 ($4,000/yr for 35 years (and a month) at a net 7.5% annual rate of return)
- Annual rate of return in retirement: 7.5%
- Tax-free retirement income: $50,000
- Social Security Income: $28,000tax-freebecause a Roth or LIRP does not count as Provisional Income
What do you notice compared to the first example where Ryan and Jen utilized a 401K? What should jump out at you is that the tax-free income here is the exact same as the after-tax income in the first example. So, why is this better? For a couple reasons:
- If taxes went up by just 1%, then the Roth/LIRP scenario produces more income. Remember, we assumed taxes stayed the same in the 401K/qualified plans example, something we believe is highly unlikely. If taxes are likely to rise, this scenario handily wins on that point alone.
- Ryan and Jen are now highly insulated against tax changes in the future. What if tax rates skyrocket, or deductions are killed off? They don’t care. Their income is tax-free.
- Social security income is now tax-free. Distributions from Roths and LlRPs do not count as Provisional Income, therefore not tainting their SSI with unnecessary taxes. In the first example, their SSI was 85% taxable. Let’s do a side-by-side comparison.
|Assumed Tax-bracket||33%||Assumed Tax-bracket||33%|
|Annual Contributions:||$6,000||Annual Contributions:||4,000|
|Annual Tax-savings:||$2,000||Annual Tax-savings:||$0|
|Total Tax-savings Over 35 Years:||$70,000||Total Tax-savings Over 35 Years:||$0|
|Distributions:||100% Taxable||Distributions:||100% Tax-free|
|Provisional Income:||Yes||Provisional Income:||No|
|Subject to Tax Increases:||Yes||Subject to Tax Increases:||No|
|Taxable to Heirs:||Yes||Taxable to Heirs:||No|
|Gross Income:||$75,000||Gross Income:||$50,000|
|Net Income:||$50,000||Net Income:||$50,000 (tax-free)|
|SSI Gross Income:||$28,000||SSI Gross Income:||$28,000|
|SSI Net Income:||$20,146||SSI Net Income:||$28,000 (tax-free)|
|Total Net Income:||$70,146||Total Net Income:||$78,000|
|Total Annual Taxes:||$32,854||Total Annual Taxes:||$0|
|Year To Pay Back IRS Tax-savings:||2.1||Year To Pay Back IRS Tax-savings:||N/A|
|Total Taxes Over 20 ears:||657,080||Total Taxes Over 20 Years: /p>||$0|
|Total Taxes Over 30 Years:||$985,620||Total Taxes Over 30 Years:||$0|
|Taxes To Heirs (Assumption 33%):||$330,000||Taxes To Heirs (Assumption 33%):||$0|
|Total Lifetime Taxes:||$987,080-1,315,620||Total Lifetime Taxes:||$70,000 (pre-tax savings sacrificed)|
This is a very simple solution that provides roughly $240,000 more income to Ryan and Jen over a 30-year retirement. That is not insignificant when on a fixed income. The peace of mind of not having your income subjected to a changing tax landscape and which party is in power in Congress (what we might term “political risk”) is difficult to value but certainly worth a lot. If taxes were raised 5%, for example, in the 401K example, Ryan and Jen’s combined net income would sink from $70,146 per year (401K and SSI income) to ~$65,450, costing them an additional $150,000 throughout a 30-year retirement.
We’ve now provided three different scenarios with varying rates of return, amounts invested, time horizons, and methods of distribution. Part 4 was a fairly simple solution meant to show a step in the right direction. But what if you already have a decent amount saved in pre-tax vehicles? Take heart. For more comprehensive scenarios on how to escape the qualified plan tax-trap and potentially enter the 0% tax-bracket upon retirement, please our post “4 Streams of Tax-free Retirement Income.”
The title of this post is “How Much Does My 401K Save Me In Taxes?” When you take into account both sides of the equation, you see a 401K (and its pre-tax siblings like 403bs, TSPs, and IRAs) can cost you a significant amount more in tax than they “save” you. You see, 401Ks/IRAs are meant to maximize the amount of taxes you pay over your lifetime. And they do a great job of that. Do not forget that IRS stands for “Internal Revenue Service.” Its job is to collect “revenue” for its client, the federal government, not to maximize your retirement savings.
Retirement planning is much about math. Don’t forget the second half of the equation when considering a 401K or other pre- tax, tax-deferred vehicle. There are advantages to these plans but approach them with caution and eyes wide open. Take the time to study and do the math. If you need help, work with a firm who understands both sides of the retirement equation and specializes in tax-free planning. That is our core competency at Axios Capital Strategies.