Psst, Hey Buddy. Wanna Get a Tax Cut?

Psst, Hey Buddy. Wanna Get a Tax Cut?

Congress and the President showcase their tax cuts as a centerpiece of their economic strategy. The Author sets out some tax-saving retirement savings strategies below that make the 2002 tax cuts look like chump change for the average wage-earner.

An effective but commonly overlooked retirement planning strategy, is to fund a 401(k) to the extent of a company’s matching amount and then contribute the money that would have been put in the 401(k) into a Roth IRA. Let’s take a look at a couple of scenarios to see how it can work. This first example compares the advantages of a Roth IRA to a Traditional IRA. The second example demonstrates the 401(k)/Roth IRA strategy.

Example 1. Josh and Jenna White are 35 years old. They plan to retire at 35, so they have 30 years until retirement. They do not have a pension plan at work. They can either contribute $8,000 to a Traditional IRA or $8,000 to a Roth IRA. We will assume that when they retire they will be in the 25% tax bracket. If they take a lump-sum distribution when they retire the lump-sum amount will push them into the 35% tax bracket. We will also assume they will get an 8% annualized return.

When Josh and Jenna retire, their IRA balance, Roth or Traditional, will be:

$264, 711 If they have a Traditional IRA and take out the entire lump sum, the amount, after taxes at the 35% rate is:

$172, 062. If they withdraw an equal amount of the proceeds over ten years, taxed at 25%, their annual withdrawal will be: $19, 853 per year.

Here is where the Roth IRA advantage becomes clear. If Josh and Jenna have a Roth, there are no taxes. They keep the ENTIRE $264, 711.

Example 2. Tim and Trina Brown are 30 years old. They plan to retire at 70, so they have 40 years until retirement. They have 401(k) plans at their work and each employer matches 401(k) contributions up to 3%. They currently contribute $10,000 to their 401(k)s. Should Tim and Trina max out their 401(k) contributions? Or should they contribute to their 401(k)s only to the extent of the company match and put the rest into a Roth IRA?

If Tim and Trina continue putting $10,000 into their 401(k)s, they will have $296, 839, as a lump sum (after tax) 401(k) withdrawal. If they take the proceeds over 10 years, they will get $34,251 per year.

However, if Tim and Trina limit their 401(k) contributions to only the company-matching amount, they will retire with $379,041. If they take it out over 10 years, they will get $38,817 per year. (These amounts include the taxes on the taxable 401(k) proceeds.)

$82, 202! That is the difference for the lump-sum withdrawal. 27% more than the 401(k) strategy. Put another way, 2.4 more years of income than the 401(k) strategy. A simple strategy that many workers may take advantage of.

The Author has an Excel Spreadsheet that calculates the relative advantages of the Roth/401(k) strategy. And if a 401(k) participant takes advantage of the company-match amount, and then reaches the Roth limit, he can still put more funds in his 401(k) up to his 401(k) limit.

November’s Desert of the Real Newsletter will explore these issues more fully.
Congress and the President showcase their tax cuts as a centerpiece of their economic strategy. The Author sets out some tax-saving retirement savings strategies below that make the 2002 tax cuts look like chump change for the average wage-earner.

An effective but commonly overlooked retirement planning strategy, is to fund a 401(k) to the extent of a company’s matching amount and then contribute the money that would have been put in the 401(k) into a Roth IRA. Let’s take a look at a couple of scenarios to see how it can work. This first example compares the advantages of a Roth IRA to a Traditional IRA. The second example demonstrates the 401(k)/Roth IRA strategy.

Example 1. Josh and Jenna White are 35 years old. They plan to retire at 35, so they have 30 years until retirement. They do not have a pension plan at work. They can either contribute $8,000 to a Traditional IRA or $8,000 to a Roth IRA. We will assume that when they retire they will be in the 25% tax bracket. If they take a lump-sum distribution when they retire the lump-sum amount will push them into the 35% tax bracket. We will also assume they will get an 8% annualized return.

When Josh and Jenna retire, their IRA balance, Roth or Traditional, will be:

$264, 711 If they have a Traditional IRA and take out the entire lump sum, the amount, after taxes at the 35% rate is:

$172, 062. If they withdraw an equal amount of the proceeds over ten years, taxed at 25%, their annual withdrawal will be: $19, 853 per year.

Here is where the Roth IRA advantage becomes clear. If Josh and Jenna have a Roth, there are no taxes. They keep the ENTIRE $264, 711.

Example 2. Tim and Trina Brown are 30 years old. They plan to retire at 70, so they have 40 years until retirement. They have 401(k) plans at their work and each employer matches 401(k) contributions up to 3%. They currently contribute $10,000 to their 401(k)s. Should Tim and Trina max out their 401(k) contributions? Or should they contribute to their 401(k)s only to the extent of the company match and put the rest into a Roth IRA?

If Tim and Trina continue putting $10,000 into their 401(k)s, they will have $296, 839, as a lump sum (after tax) 401(k) withdrawal. If they take the proceeds over 10 years, they will get $34,251 per year.

However, if Tim and Trina limit their 401(k) contributions to only the company-matching amount, they will retire with $379,041. If they take it out over 10 years, they will get $38,817 per year. (These amounts include the taxes on the taxable 401(k) proceeds.)

$82, 202! That is the difference for the lump-sum withdrawal. 27% more than the 401(k) strategy. Put another way, 2.4 more years of income than the 401(k) strategy. A simple strategy that many workers may take advantage of.

The Author has an Excel Spreadsheet that calculates the relative advantages of the Roth/401(k) strategy. And if a 401(k) participant takes advantage of the company-match amount, and then reaches the Roth limit, he can still put more funds in his 401(k) up to his 401(k) limit.

November’s Desert of the Real Newsletter will explore these issues more fully.