Pre-Tax vs Roth: The Real Math Behind Paying Taxes Now or Later
“So I’m going to get a deduction today but have to pay tax later when I pull the money out when my money is 5x the size?”
This was a question I had this past week and I can easily see the confusion.
In the case of a pre-tax qualified account contribution, you receive a tax deduction today, the money grows, then you pay tax later.
If you defer $300,000 today and it grows to $1,000,000 by the time you pull it out, it’s easy to see how the size of the account, and the amount of tax paid, is higher…
How is this a good deal?
The key is, it’s not about the size of the account - it’s about the tax rate you defer money at vs the tax rate when you pull money out.
If your tax rate is lower in retirement, then pre-tax contributions will save you money.
If your tax rate is higher in retirement, then paying tax upfront, will save you money.
Let’s let the numbers do the talking here.
Pre tax = you start with $300,000, for 30 years, your tax rate is 22%, the money grows at 6% for 30 years and you end up with $1,723,047, then you pull that money out and assuming you also pay 22% on the way out, you’re left with $1,343,976.
Post tax (roth) = you start with $300,000, for 30 years, your tax rate is 22% so after tax you’re investing $234,000, the money grows at 6% for 30 years and you end up with $1,343,976, then you pull that money out & you don’t owe taxes.
This proves the idea that your tax rate determines your tax savings based on when you defer.
That said, there’s two ideas I’ve been playing with that I think change the numbers here:
When you make pretax contributions, you’re deferring income at your highest marginal tax rate. Then when you pull money out later, assuming you have $0 income, you get the benefit of lower brackets on your way up to the 22% bracket. So while you may have the same marginal rate, your average tax rate (or effective tax rate) on the total amount distributed is less even when marginal rates are the same. This adds an advantage to pre-tax accounts.
When you make a pre-tax contribution, you get an immediate benefit in the year you make the contribution in the form of a tax deduction. This results in an additional savings today that theoretically could be invested adding an additional benefit for pre-tax savers, assuming you’re disciplined enough to figure out what your taxes owed would have been and actually save it.
If you’re considering the angle of taxes and thinking that tax rates are going up over time…
Think again.
If you consider this through the lens of taxes, since 1913 tax rates have fallen.
The highest marginal tax rate in 1957 was 91%.
Since 1989 we’ve seen more of a stabilization of the highest marginal rate around 30%.
Who knows what’s going to happen to tax rates looking forward but what I like to emphasize here is two things:
Adding as much flexibility to your plan as possible.
Knowing yourself and income trajectory.
I’ve met a total of 0 people who have not valued having flexibility in their plan, rigidity is something very few like & more specifically when it comes to your money comes in the form of missed opportunity.
We’re not betting that you hit the lottery, rather, using reason and logic to help us make better decisions today with your money.
If you’re young and plan to have a long and successful career - Roth may make sense early.
So, whether it’s Roth, pre-tax, or a blend of both, the goal is the same, use logic, stay flexible, and make sure your future self has options.