As discussed earlier, the mathematical assessment of the pre-tax-vs.-after-tax decision is dependent on a projection of future tax rates. But no matter how optimistic or cynical your view of governmental decision making, there is no way to divine future tax policies and their impact. So…
Given the absence of any reasonable mathematical paradigm on which to make a decision, some individuals may operate from a different premise: select the option that offers a higher level of financial certainty. Most business owners will say financial certainty–even the certainty of higher costs or lower profits–gives them a planning advantage. Certainty in one aspect allows others to be adjusted, and clarifies the steps needed to address future challenges. Individual savers are no different.
If you select a Roth format, the current tax costs, while perhaps steep, are known quantities. And so is your future tax status–distributions are tax-free. In contrast, a decision to defer the tax on a 401(k) offers clearly defined up-front tax savings, but introduces future financial uncertainty, because the cost of taxation won’t be known until the money is withdrawn. Who knows what those costs will be, and how they may affect your ability to enjoy the distributions?
Considering the regularity with which Congress alters the tax code, a 20- or 30-year period between deposit and withdrawal exposes one’s pre-tax retirement account to a lot of potential tax changes. Since the money has yet to be taxed, it is easier for Congress to rationalize adjusting the distribution terms for pre-tax accounts. For after-tax savers who have already paid the tax according to current law, it is conceivable that future legislation could revoke the tax-free status of both accumulations and withdrawals from Roth accounts. But the political fall-out would undoubtedly be far greater; it would appear the government was breaking faith with account holders by taxing them twice.
For committed savers with longer time horizons (20 years or more), the financial certainty of paying tax today may be more desirable than waiting for the tax hammer of unknown force to fall in retirement. But the challenge to choosing the long-term financial certainty of a Roth account may be affordability. If your marginal tax rate is 30%, and the goal is to deposit $10,000 a year toward retirement, gross earnings must be $14,285 to net a $10,000 after-tax Roth deposit. A pre-tax saver using a 401(k) needs only $10,000–and the willingness to take the risk of whatever the future tax cost will be.
Conversely, savers with high current income, limited retirement assets, and shorter time frames may find greater certainty in pre-tax deposits. With a shorter accumulation period and a greater disparity between anticipated retirement and pre-retirement income, the prospects of retiring into a lower tax bracket increase. It may be an over-simplification, but under-achieving savers stand to benefit most from pre-tax plans while after-tax plans probably favor “prodigious accumulators of wealth” (a phrase coined by William Danko in The Millionaire Next Door).
Are there other tax-free accumulation alternatives?
The most attractive feature for both pre-tax and after-tax retirement plans is the tax-free growth during the accumulation period. This allows for maximum compounding, as gains are not diminished by annual taxes on dividends or capital gains. However, both pre-tax and after-tax qualified retirement plans impose penalties on early distributions (i.e., prior to age 59?), and both types of plans are constrained by annual contribution limits. But suppose your financial plans include objectives with shorter time horizons, or a particularly profitable year means additional dollars for investment. Are there other tax-free accumulation options?
With careful planning, it is possible to construct a tax-favored accumulation program outside of a qualified retirement plan. Many municipal debt instruments issued by local and state governments have tax-favored benefits in regard to interest payments. Life insurance cash values allow for inside buildup without tax and, under specific terms, may be withdrawn or borrowed on a tax-free basis. When shares of stock and real estate holdings appreciate, the growth is tax-free, with a capital gains tax due only upon the sale of the asset. These alternative products have unique benefits as well as limitations, so expert assistance is recommended. But, depending on your individual circumstances, non-qualified accumulation instruments may either complement or surpass qualified retirement plans as vehicles for tax-favored accumulation.
Beyond the specifics of pre-tax/after-tax or qualified/non-qualified accumulation programs, higher taxes compel consumers to stay on top of their allocation decisions. Taxes not only diminish immediate returns, but also exact ongoing opportunity costs. The sooner you start accumulating on a tax-favored basis, the better.
Elozor Preil, RICP®, CLTC is Managing Director at Wealth Advisory Group and Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). He can be reached at [email protected]. See www.wagroupllc.com/epreil for full disclosures and disclaimers. Guardian, its subsidiaries, agents, or employees do not give tax or legal advice. You should consult your tax or legal advisor regarding your individual situation.
By Elozor M. Preil
