First, if your tax brackets and total percentage of taxes were the same both before and after retirement, you’d end up with exactly the same amount after taxes. The taxes you don’t pay now but invest for yourself would grow just enough to pay the taxes on the larger total after retirement.

Second, chances are your total taxes after retirement will be a smaller percentage than the amount you get to deduct for your contributions to retirement during your working years, even if taxes are increased considerably. Here’s why:

Many people use only the marginal (highest) tax bracket for comparison. Actually, with a tax deferred plan you get to defer taxes on your contributions in your highest tax bracket and invest that money now. But because of the standard or itemized deductions, personal exemptions, graduated brackets for percentages of tax, and tax credits, the total percentage of income tax paid in a year is considerably less than the top bracket.

For example:

A single person earning $70,000 contributing 15. % ($10500) to a 401(k) and taking the standard deduction of $6,100 and personal exemption of $3900 has a taxable income of $49,500. They’d pay $8,304 federal income tax, $1,015 Medicare, and $4,340 Social Security taxes. They pay their top bracket of 25.% on the top $13,250 of their income. Their federal income tax is actually only 11.86% of their wages.

The deductions, exemptions, and steps between brackets go up with inflation. So even after inflation, an extra across-the-board percentage increase of 50% in each tax bracket would still only make their total taxes about 17.79% of their income – compared to 25% that they deferred paying on their contributions to retirement.

Furthermore, after retirement you won’t need to withdraw as much from your retirement account even if you needed exactly the same take-home pay. You would not be contributing anything to to retirement and would not pay FICA taxes on any pensions, withdrawals from retirement accounts or social security income.

Depending on your income from other sources, you might not pay much if any income tax on your social security income either. In Georgia where I live you’d get to defer 6% state income tax and pay no income tax on retirement income or withdrawals from the tax-deferred accounts. Or you might defer taxes in a state that has an income tax and then retire in a state that has no income tax. In these cases, a tax deferred plan is even better.

jimb

2. You have no control over the return you will earn. When you put your money in the hands of other people you lose control. Keep in mind, it’s much easier to overcome losses than people think, If you lose 20% in one year, you’ll have to earn 25% the following year just to be back to “break even” Losses early on can be devastating.

3. It’s a “poor-mans” way to plan. I personally believe based on the way our government has been managed in the past and will be managed in the future taxes are only going to increase in the future. Traditional IRA distributions are taxed at your ordinary income tax rate when you begin taking them. Unless you plan on being poor and earning no money during retirement (hopefully you’ve made solid investments that generate a passive income) you will be taxed much more at retirement than just taking you lumps now and freeing that money up to do whatever you want with it.

4. Lastly, think about this point. This is a government retirement plan. Who do you think the government is really looking out for? You or them? It’s rigged up to save you a little cash now through a lower taxable income, but to break your bank in the future when you’ll need the money the most.

What constitutes an emergency?

I absolutely agree with you both and encourage your explaining the different options people have when it comes to retirement plans. It’s fantastic!

It is critical, though, Brett and Kate, to have an understanding of the trends in the actual value of a particular currency before diving into a long-term savings plan that are denominated in just one currency, like a 401(k).

I hope you will be cautious in recommending investments that are based solely in devaluing currencies like the US dollar.

As 401(k) plans mainly invest in the common stock of American companies, I hope you both understand that the average 401(k) investor will largely be at a net loss in actual purchasing power by the time s/he has access to the plan’s monies.

I submit for your review a of couple points I hope you consider when looking beyond the pro’s of investing (like company matching and tax deferment – which actually may turn out to work against you) in a 401(k) as your primary retirement vehicle:

1. Inflation.
Consider the affect the trillions of dollars in stimulus and bail-out funds are having on the value of our currency. Also consider the effect T-bills that are currently owned by other countries and non-nation sovereign wealth funds will have on the value of our currency when they mature.

2. The priority of common stock dividends.
The executive teams that run the businesses in which your 401(k) invests don’t always have the common stock holder’s best interests in mind. If a company in your portfolio is bailed out by the government, that lender is the first on the list to pay when a business makes money. Next is the corporate bondholders. Then preferred stock holders. Then the company has the option to hold any extra money as retained earnings. If the company wants to only hold some, or none at all, then a dividend payout is awarded to the common stock holders.

3. The fate of the companies in which were invested.
The assumption the companies that are being invested in by the 401(k) will not only be around by the time you retire, but have continually expanded (particularly in stock price and future earnings potential).

4. A buyer of your stock.
The assumption a third party will be willing to pay for the (hopefully) higher price of the stock when you retire. Hopefully the gains in the stock price out-pace inflation, and…

5. Taxes.
The assumption that the tax you will pay in the future on both the principal invested (since you deferred tax when you put the money in) and the capital gains that you made over time aren’t higher than they are currently. They certainly won’t be lower, but if they are higher when you want to take the money out, hopefully the returns your 401(k) made not only beat inflation, but also can handle the bigger chunk the government will take out in taxes.

I’m not trying to undermine your article, but provide another perspective on the options you both discuss. Keep up the good work!

1. Early withdrawals from Roth IRA’s are generally subject to 10% penalty, but not taxed as income unless in excess of their cost basis (sum invested).

2. Lot of sketchy math going on here. Choice between Roth IRA v. IRA has nothing to do with ‘compounding gains growing tax-free’ or interest and principal returned tax-free. Only factor is tax rates. If you think they will be higher when you retire than what you pay now, Roth is the choice; if lower during retirement choose traditional. It is true the Roth option allows you to save more as it is an after tax contribution. Other factors to consider are that many younger/middle aged people have mortgage/student loan/other deductible debt while younger that lower their effective taxable income. You hope to be done paying those off by retirement, thereby increasing your effective income.

Last point about why traditional IRA’s are funny: Who wants to retire making less, nominally, than they do today? Either that or they think tax rates are going down, which is highly unlikely over the long-term.

Also, I have always wondered whether the $5,000 limits of the traditional and Roth IRA’s are exclusive. I am not in a financial position to max my contributions to both, so I don’t have personal experience with this. But could you fully fund one of each account? I assume that the $5,000 limit applies to all of your IRA’s, Roth or otherwise.

With IRA’s, like other retirement accounts and insurance policies, you list a beneficiary(ies). A single person would usually list their parents, while others would list a spouse. They would then inherit the IRA as is.

There are some other issues regarding the potential tax aspect, but probably beyond the scope of your question.

In summary, whomever you list gets it. If you don’t list anyone, then it goes to your estate and a probate court will decide who gets it. That’s why it’s best to always list a beneficiary.

I had a instance where a clients mom did not double check the beneficiaries on one of her accounts. The outcome was not pretty: http://www.goodfinancialcents.com/beneficiary-review-designation-form-life-insurance-retirement-accounts/