Numbers Don’t Lie, They Just Muddle

I see a bunch of confusing, twisted numbers in hundreds (if not thousands) of colorful, convincing 401(k), 403(b), IRA and TSA brochures – and on some websites. These sources usually portray – and wrongfully profess - that all things being equal using pre-tax contributions and deferring taxes will result in a bigger nest egg. Therefore, those who use such accounts will end up with higher net spendable incomes. That’s simply not true.

Our firm has proved over and over again that, if a nest egg is taxable (all qualified plans are under current law) you can still run out of money! Someone who uses after-tax contributions - under the same set of circumstances - will end up with the same outcome but with much less restrictions and more certainty (in terms of taxes).

Mathematical ILLUSION

Let’s assume a return of 7.2 percent (Rule of 72 makes for easy math) and a 25 percent federal marginal tax rate (presently every dollar over $33,950 -single and $67,900 – married filing jointly - is taxed at this rate).

$200,000 in pre-tax contributions will double to $400,846.27 in ten years. If you take the same $200,000 and pay tax on the front end ($200,000 minus 25 percent tax), it amounts to $150,000. When that doubles, it grows to $300,643.70. It looks - as if – using pre-tax dollars is better than using the already-taxed (75-cent) dollars. So the illusion is that there is $100,202.57 less in the after-tax-dollar account. Or is it?

What those brochures/websites (and the consultants who use them) don’t explain is that taxes are due and MUST be paid on the entire $400,846.27 tax-deferred nest egg – upon voluntary withdrawal or when compelled by the IRS.

Once that happens, you end up with the same amount of money! Based on our example, the $400,846.27 minus 25 percent tax will net you $300,634.70. There is no difference between funding a retirement account with after-tax dollars or pre-tax dollars, assuming the same tax bracket and provided that the account funded with after-tax money grows and stays tax-free upon withdrawal (as they are under current law). Interesting, huh?

Y’see, the misconception is that because the pre-tax dollars grow to a bigger number it’s better. Remember, the supposed bigger balance includes unpaid taxes and the last time I checked, the IRS doesn’t play.

Other worthwhile facts to note

• As you approach retirement (if you’re like most retirees), you’ll have fewer deductions and exemptions compared to your earning years. That would probably bump up your tax bracket.
• Tax due on a pre-tax contribution account is based on rates in effect at the time of withdrawal (whether voluntary or compelled by the IRS).
• If you were the owner of the $300,634.70 tax-free account used in this example, you’ll not lose sleep over future tax rates. Why? Because your income is NOT taxable.

The next time you see one of those colorful brochures think about YOUR retirement.