By Jason Watson, CPA
Posted Saturday, November 5, 2023
Two arguments abound when considering a pre-tax 401k contribution. The argument goes like this- your retirement tax rate will be lower than your wage-earning tax rate. For those in the 32%, 35% or 37% marginal tax brackets, this is likely true. However, those earning big bucks probably continue to earn big bucks during retirement from investments, real estate, consulting, etc.
The other argument is about the free loan from the IRS. If you contribute $30,500 to your pre-tax 401k and you are in the 32% marginal tax bracket, you just put $9,760 in your pocket ($30,500 x 32%). Sure, at some point the IRS wants it back when you withdraw it during retirement and will tax the original contribution plus whatever you earned on it. But this might fall into the let’s worry about next time, next time category.
As such, the second argument is about using the IRS’s money to build additional wealth. You take your $9,760 and do something good with it. Yeah, this argument sort of works. $9,760 annually might not move the needles much on your wealth building strategies. You would need $9,760 x 10 years at 6% rate of return just to afford a down payment on an average rental property.
Rather, most wealth is built with after-tax dollars. The leveraging of the IRS free loan concept sounds great on paper until you gain perspective on the size of the lever.
Another side argument is completely avoiding state income taxes by reducing your state income and therefore income tax with 401k contributions during your wage-earning years, and then establish residency in a tax-free or a tax-friendly state during retirement.
The theories above make sense; however, we ask a basic question- is it easier to pay taxes during your wage-earning years or during retirement? Sure, it depends how much you withdraw during retirement. Please consider that to spend $150,000 during retirement, you might have to withdraw upwards of $180,000 to account for the income taxes.
During your wage-earning years you might have the ability to work a little harder to pay for taxes now. Pick up an extra shift. Close an extra deal. Get a few more tax returns out of the door if you are a tax accountant. Whatever it takes, right? During your retirement years, especially mid-70s or older, you pay taxes with retirement savings (or at least it feels like you do depending on your cash sources).
Also, keep in mind that your primary objective in life is to build wealth. Your second objective is to save taxes, and what a lot of people forget about is saving taxes is not done in a vacuum or just one year; it is done over your entire lifetime.
Finally, consider that the law of 72 suggests that your investments will double every 8 years. Huh? The average rate of return for the S&P 500 is 9.2% since inception. If you take 72 and divide it by 9 (the rate of return) this equals 8, and suggests that your investment will double in 8 years. Where are we going with this? If you have 2 or 3 “doubles” coming up, to have that growth be tax-free upon retirement might be nice.
As mentioned elsewhere, WCG CPAs & Advisors recommends financial planning by a qualified planner to determine your objectives and model your particular scenario.
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