We look at a lot of 401K statements in the course of a year. It’s important for us to know how much you are contributing, how much your employer is matching your contributions and how the money is being allocated between a menu of funds your employer offers. In almost every situation we see, contributions to the plan are going in pre-tax. In other words, the contribution is coming off the top and has never been taxed. People do this because the messaging has always been: “lower your taxable income now while you are working and are in a higher tax bracket and then you will eventually pull the money out in retirement when you will be in a lower tax bracket”. Well, that messaging begs the question, is it really true? Before you read more about our detailed yet simple analysis, you can stop here and contact your company’s 401K administrator and change your pre-tax contribution election to post-tax/Roth 401K! If you want some more details, please read on.
We are attempting to look at at lifetime values net of taxes. Our analysis is comprised of some assumptions that we will outline here:
- 401K participant is age 45
- Participant plans to retire at age 67
- Participant dies at age 92.
- Participant is invested in an 80% stock/20% bond allocation that averages 6.24% average annual return based on current capital market assumptions. The historical return is actually 8.2% on average. So we are using return assumptions that are 2% lower per year! You would be amazed at what a 2% higher return means over 40-50 years!
- Participant is investing $22,500/yr into the 401K plan. We are not inflating or including any catch-up, or company match.
- We are not accounting for spending/withdrawals, social security, or any other cash flows
- We are assuming a 25% flat tax rate for participant while working, retired, and for their heirs.
So, let’s dive right into the numbers. First if this participant invests in the pre-tax 401K, they would have contributed a total of $472,500 over twenty-one years and received a tax benefit of $118,125 because the money went in before being taxed. After twenty-one years of contributions, this participant would have accumulated $1,134,000. This sum grows to $4,277,000 at age 92 assuming it just sits there. Adding in the tax deduction received, the real money was really $4,396,000! This value is made up of that which is still in the IRA ($1,713,000) and that which came out as required minimum distributions starting at age 75, was taxed, and the net was reinvested in a non-IRA account. The total in the non-IRA was $2,509,000. Any gains at death will receive a stepped-up basis according to current tax law. However, the portion still remaining in the IRA will be taxed by the heirs. The total tax paid by the heirs is $428,000 at a 25% tax rate! The IRA account must now also be emptied within ten years of death. So, the net after-tax value is $3,967,000.
Calculating the net on the post-tax/Roth 401K account is much easier! In this case the 401K grows to the same $1,134,000 by retirement age and $5,152,000 by age 92. Extra tax paid on post tax contributions would be $234,000, so, the total money in this case is $4,917,000. However, the difference is that no taxes are paid on the money coming out of the post-tax/Roth 401K account EVER! There is actually a $1,000,000 advantage (all taxes accounted for) in using the Roth 401K option over the pre-tax 401K, based on the assumptions we have outlined. Now, is a 25% level tax rate realistic? Probably not! And, are all the other assumptions realistic? No, there are a lot more in’s and out’s over the course of a lifetime. But, this analysis will at least start to get you thinking!