Retirement – Part II: Do I really need all these accounts?

Hello and welcome back my dear readers. Today we are continuing our series on retirement that started with a brief history on retirement in the good ol’ US of A. Here we are going to build on the last post which explained the differences between retirement accounts. If you are not familiar with these accounts, or would like to read a whimsical explanation of them, please check it out. I’ll be patiently waiting.

Today we are going to look at what happens when you withdraw the money, and consequently, why you should have both a traditional IRA type and Roth type retirement account. Let’s start with what happens when you withdraw the money.

Getting Your Money Back Out

Let’s now assume that you have reached the ripe old age of 60 years old. Now the government agrees that you have come of age (of sorts). You are now finally able to withdraw all that hard earned money you put into retirement accounts without any penalties or shenanigans.

So what happens? Well, the answer depends on question #2 from the last post: How did you fund the retirement account?

If you filled the retirement account with pre-tax money (ex. 401k or a traditional IRA retirement account) then you now have to pay the income tax. How much? It depends on how much you withdrew and if you made any other income that year. See, every dollar that comes out of this account counts as income and is taxed at the corresponding incremental rate.

Huh?

In the US, we have a progressive tax system that taxes each successive increment of income at a progressively higher rate. For example, let’s suppose we have a fictitious tax system (like the US) with 3 tax brackets:

  • $0-$100: taxed at 10%
  • $101 – $1000: taxed at 20%
  • $1001+: taxed at 30%

Under this system, if you make $1500 a year, your first $100 will be taxed at 10%, so you owe $10. Your next $900 is taxed at 20%, which means you owe $180. Your final $500 is taxed at 30%, which means you owe $150. So your total tax bill is $10 + $180 + $150 = $340.

Importantly, your marginal tax (read – highest) rate is 30% but this does not mean you pay 30% tax (that would be $450). Your tax bill is $340 which is actually 22.67%.

Now, when you go to withdraw money from retirement accounts, like the 401k that was filled with pre-tax income, you must pay your fair share of taxes. So if you withdraw $100 you pay 10% tax. If you withdraw $1500, you pay 22.67% tax.

If you filled your account with post-tax money, then you can withdraw your money as if it were in a savings account, meaning you owe no taxes.

The Big Catch

You might think, ‘I’ve got enough in savings accounts! In order to avoid taxes, I will just sit on my IRA money!’ Wrong! You see Uncle Sam says that you must withdraw all money from pre-tax retirement accounts by the end of your time here on earth. To do so, the government has decided that you must begin making withdrawals by age 70 in order to ideally drain the account. Uncle Sam wants his cut and he will get it, one way or another.

Now if you filled your account with AFTER-tax money then you don’t need to pay any tax on what you take out. That money does not count as income! Again, that money is very similar to money you are holding in a savings account.¬†Uncle Sam doesn’t want his cut. He already got some. So you are free to leave that account brimming with dollars long after you are gone.

So which account is better?

If you use one type of retirement account, you pay income tax when you retire, but none now. If you use another type of retirement account, you pay taxes now but not later. You may say, ‘But if I use my traditional IRA then I get more in there now, isn’t this better?’

Maybe. Putting in pre-tax money now and paying tax later assumes you will pay less taxes when you are retired because theoretically your income will be lower, meaning you are taxed at a lower rate. This would generally be true UNLESS the tax rates increase.

To this end, there is an endless chorus of naysayers that insist that the pre-tax retirement accounts are a bad deal because taxes WILL go up.

So are they right?

To be fair, the naysayers have a point because all that matters is how much tax you will pay at the end (while withdrawing) on the pre-tax retirement account. If the tax rate that you are paying now on your income and the tax rate you will pay when you withdraw from your pre-tax retirement accounts is the same, then the outcome with regard to how much you will get from the Roth IRA vs the Traditional IRA is nearly the same.

Confused? Well, consider a simple example. We have 2 accounts. One is a traditional IRA, one is Roth IRA. We contribute $100 each year to both accounts. We tax the Roth account contributions at 25%, so only $75 is actually contributed annually to that account. We tax any withdrawals from the traditional IRA account at 25%, but the full $100 is contributed each year.

For each year, we plot the value of the accounts in both cases as if we are withdrawing all of the money from the corresponding account in that year. This means the pre-tax retirement account is taxed at 25% in its entirety and the post-tax retirement account is not taxed upon withdrawal. Remember the Roth account contributions were taxed when the contribution was made, so only $75 was deposited. We assume a modest growth rate of 5%. Here is what we find:

It looks like the Roth account is actually better! That’s because we incrementally collected the tax on the contributions but never on the growth inside the account. The IRA account was flatly taxed upon withdrawal which means that we paid tax on the contributions AND the growth.

Now suppose, as the naysayers think, the tax rates go to 35% at year 10. What will this graph look like?

First of all, everyone lost because taxes ate into everyone’s savings. But second, the account funded with after-tax money did even better! Roth wins again!

So What Should You Do?

But suppose now that you were smart. You realized that the traditional IRA is treated as income and the Roth account is treated as savings. And because of this, you could balance how much you withdrew from the IRA type account and how much you withdrew from the Roth type account.

If you did this, you might carefully look over the incremental tax brackets  (see above) and select the highest rate at which you want to be taxed. So for example, suppose instead of withdrawing all of the IRA account each year, you withdrew 1/4. For the rest you supplemented your budget with the Roth account (of course). In this case, your income is much smaller. So much so that your tax rate falls to say 10% (for example).

In this case, we can project how much the retirement accounts are worth again. Only this time, we project the account worth not the amount we can withdraw as in the plots above. A bit more complicated math, I’ll spare you the details, but here is the value of both accounts per year:

Interestingly, the pre-tax IRA account appears to be larger. This is because we have effectively reduced the taxes which will be assessed on this retirement account. Effectively we have “increased” the value of our pre-tax retirement contributions.

More directly to the point, we have realized that the US tax system is not flat. We have leveraged this fact to improve how much money we ultimately get for our hard work and savings.

The Solution

So with all this in mind, putting together the miserable history of retirement, the types of accounts available, and the analysis above, the Handy Millennial recommends that you have both Roth and traditional retirement accounts. Why? Because when you have two types of accounts, a pre-tax and a post-tax retirement account, you can withdraw some money that is considered income and some money which is considered savings. You can trade off how much to withdraw from where to minimize your tax burden.

So having both accounts means that you have flexibility. And while the Handy Millennial absolutely could not tell you what the tax rates will be in 30 years, he does believe in flexibility and being able to manage how much you will pay in taxes.

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