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Should I pay tax now or later?

Should I pay tax now or later with retirement plan contributions?

There are two type of contributions for retirement: before-tax and after-tax (a.k.a. Roth). If you are contributing to an outside retirement account before tax, you would be contributing to the IRA. The individual retirement account allows before-tax dollars to grow tax deferred until retirement. When you pull out these dollars in retirement, you will pay tax to the IRS on the entire amount withdrawn, including earnings.

Here is an example of the tax treatment of before-tax dollars in retirement:

Ex. $500,000 IRA
withdraw $2,000/month
$440 is tax paid to the IRS (assuming a 22% bracket)
Net withdrawal: $1,560

What are the benefits to contributing to a before-tax account?

1) Tax Deductible: Assuming that your income doesn’t preclude you from doing so, IRA contributions are tax deductible in the current tax year.

ex. Let’s say Jill’s income is $60,000 and she contribute the max to an IRA - $5,500.

Her taxable income for the year is:

$60,000 – $5,500 (deductible IRA contribution)= $54,500
That’s a nice tax break today!

2) Tax Bracket in Retirement: If you think that you will be in a substantially lower tax bracket in retirement than you are today, then it might be advantageous to contribute before-tax. Another unknown factor here is that we don’t truly know what tax brackets will be in the future.

 

Who should contribute to after-tax (Roth) accounts?

With the Roth IRA, the after-tax cousin of the IRA, you can contribute the same $5,500 per year that will grow tax deferred.  Note that with after-tax accounts, the earnings is tax free in retirement.

Let’s contrast that with the same $60,000 earner above. Jane’s 2017 taxable income is $60,000 with no tax deduction today. In retirement, she doesn’t owe tax on her $2,000/month withdrawals because it is all tax free money.

Note – there are income limitations for the Roth IRA, but Jill is below them with her income.


Finally – what does this have to do with my 401k?

Let me explain the relationship between before-tax and after-tax IRAs and your workplace 401(k). Not all workplace 401(k) plans have the Roth 401(k), but let’s assume yours does. You can contribute to the Roth 401(k) and your dollars grow just like they do in Jill’s Roth IRA. To contrast this, if you contribute to the traditional 401(k), the dollars inside are treated like Jill’s before-tax, tax-deductible IRA. A few differences between these vehicles is the contribution amount is much higher for the workplace 401(k) and with the Roth 401(k) there are NO income limitations like the Roth IRA.

You can contribute to a workplace retirement plan and an outside IRA/Roth IRA. But there are certain rules with IRA’s that you want to watch out for.

This chart helps to organize the similarities and differences:

Tax now or Later Chart

What’s a general rule of thumb?

Generally, the Roth IRA or Roth 401k can be beneficial for younger investors or individuals in a low to medium tax bracket. As for the before-tax accounts, the tax deduction can be especially helpful for for self-employed business owners or individuals in the upper-medium to high tax brackets. This depends entirely on your personal financial situation and your retirement goals.

 

IRA strategies implementing various tax strategies or tax codes may not be appropriate for all investors.  Please consult your investment and tax professional prior to implementing a strategy.