Pretax versus After tax

Pretax Savings versus After-tax Savings

Much has been said with regard to saving money pretax as opposed to after tax. But is it really better? Putting money in tax-deferred savings reduces taxes now but what about later on? Why is it better to pay taxes down the road instead of now?

To illustrate why pretax savings is better than after tax, we'll give an example. In our example, a couple aged 45 making $60,000 annually, plans to save for retirement at age 65. They have a fixed amount of living expenses which must remain constant regardless of how they save (this amount will be conveniently set at $44,236). We'll present three methods of savings and the consequences of each.

In the three scenarios, we'll simplify a few things so that the "answers" are more readily identifiable.

First, we disregard inflation so that all numbers can be compared to today's dollars. This also allows us to use current tax rates. We assume a relatively low (3%) investment return because inflation is not included.

Second, we assume that there are no pay increases. While pay tends to increase as you continue working, it is not a necessary element in demonstrating the tax effects.

Last, we only consider federal taxes, since FICA taxes are paid on your entire income and cannot be reduced through savings.

Scenario 1: they save pretax money in a qualified retirement plan that has no match. They determine they can save 10% of their total income, or $6,000 each year (made evenly throughout) and still have $44,236 take home. They arrive at that by paying $9,764 in taxes on the taxable income of $54,000.

At the end of 20 years, the couple will have contributed $120,000 to the plan and earned $43,641 at a rate of 3% a year, for a total of $163,641 (see below).

Scenario 2: they save after-tax money in a qualified retirement plan that has no match. They must pay taxes on their contributions to the plan each year but the earnings will not be taxed until they retire. Therefore they must pay $11,444 in taxes on the full $60,000, leaving them with $48,556. They can save $4,320 each year and still have $44,236 take home.

At the end of 20 years, the couple will have contributed $86,400 to the plan and earned $31,421 at a rate of 3% a year, for a total of $117,821 (see below).

Scenario 3: they save after-tax money outside of a qualified retirement plan, receiving no match and having fully taxable earnings. They must pay taxes on the money they save each year as well as the annual earnings on their savings. They plan to pay the taxes on the savings from the savings itself. As in scenario 2, they can still save $4,320 each year and have $44,236 take home, but their savings will have 28% (their marginal tax rate) less earnings each year because of taxes.

At the end of 20 years, the couple will have contributed $86,400 to the plan and earned $22,623 at a rate of 3% a year, for a total of $109,023 (see below).

**Year-by-year breakdown of savings**
Year	Scenario1 Contribution	Scenario1 Earnings	Scenario1 Balance	Scenario2&3 Contribution	Scenario2 Earnings	Scenario2 Balance	Scenario3 Earnings	Scenario3 Balance
1	6,000	90	6,090	4,320	65	4,385	47	4,367
2	6,000	273	12,363	4,320	196	8,901	141	8,828
3	6,000	461	18,824	4,320	332	13,553	239	13,387
4	6,000	655	25,478	4,320	471	18,344	339	18,046
5	6,000	854	32,333	4,320	615	23,279	443	22,809
6	6,000	1,060	39,393	4,320	763	28,363	549	27,679
7	6,000	1,272	46,664	4,320	916	33,598	659	32,658
8	6,000	1,490	54,154	4,320	1,073	38,991	772	37,750
9	6,000	1,715	61,869	4,320	1,235	44,546	889	42,959
10	6,000	1,946	69,815	4,320	1,401	50,267	1,009	48,288
11	6,000	2,184	77,999	4,320	1,573	56,160	1,132	53,741
12	6,000	2,430	86,429	4,320	1,750	62,229	1,260	59,320
13	6,000	2,683	95,112	4,320	1,932	68,481	1,391	65,031
14	6,000	2,943	104,056	4,320	2,119	74,920	1,526	70,877
15	6,000	3,212	113,267	4,320	2,312	81,553	1,665	76,862
16	6,000	3,488	122,755	4,320	2,511	88,384	1,808	82,990
17	6,000	3,773	132,528	4,320	2,716	95,420	1,956	89,266
18	6,000	4,066	142,594	4,320	2,927	102,668	2,108	95,693
19	6,000	4,368	152,962	4,320	3,145	110,132	2,264	102,278
20	6,000	4,679	163,641	4,320	3,369	117,821	2,426	109,023

Totals	120,000	43,641	163,641	86,400	31,421	117,821	22,623	109,023

Here's a break down of the account balances:

Scenario	1	2	3
Total Savings	$163,641	$117,821	$109,023

Clearly scenario 1 allowed them to save more money, but now that they're retired, they have to pay taxes on the entire amount. In scenario 2, they only have to pay taxes on the earnings their savings made, and under scenario 3, they don't have to pay taxes on any of their savings.

One way to compare the numbers is to assume they purchase a joint and survivor annuity with their savings. ABC insurance company will sell them an annual annuity based on their age and health equal to 1/10th of their balance. Thus the three scenarios produce annual annuities equal to:

Scenario	1	2	3
Total Savings	$16,364	$11,782	$10,902

Now we can determine the tax consequences of each scenario by adding the above annuities to their other sources of retirement income. We'll assume they get $20,000 annually from Social Security and $10,000 annually from pensions.

Taxation on retirement income is a little more complicated than on employment income. You can be taxed on a portion of your Social Security income from nothing to 85%. To keep things simple, we assume that half the Social Security is taxable, or $10,000 annually.

Next, depending on how you saved, anywhere from none to all of your savings income can be taxed. The amount of the savings that you've already paid taxes on is considered your "tax basis". You don't have to pay taxes on the same money twice, so you are entitled to subtract your tax basis from your retirement income. If an annuity is purchased with your savings income, then a portion of your tax basis can be deducted each year until it is completely gone. Under IRS rules, persons retiring at age 65 receive 260 monthly payments before their tax basis runs out.

Given all that, here's how their tax situation in retirement adds up under the three scenarios:

**Annual Retirement Income after 20 Years of Saving**
Scenario	1	2	3
Total Income (a)	$46,364	$41,782	$40,902
Taxable Income
Social Security (b)	$20,000 � 2 = $10,000
Pension (c)	$10,000
Savings Annuity (d)	$16,364	$11,782	$10,902
Tax Basis (e)	$0	$86,400 � 260 x 12 = $3,988	$109,023 � 260 x 12 = $5,032
Taxable Income (f) (b+c+d-e)	$36,364	$27,794	$25,870
Taxes	$5,455	$4,169	$3,881
Take-Home Pay (a)-(f)	$40,909	$37,613	$37,022
Pretax Improvement	10.3%	1.4%	0%

Scenario 1 requires that they pay more taxes in retirement but they will have more money to do so. Also, after their tax basis runs out in their 80's, taxes under scenario 1 & 2 will increase thus lowering their take-home pay even further.

The relative advantages of pretax savings increases over time. The pretax improvement would be greater if the couple saved for more than 20 years and less if they saved for a shorter period. For example, if they saved for 30 years, the pretax improvement of the scenarios would be:

Scenario	1	2	3
Pretax Improvement	14.7%	3.4%	0%

Pretax savings is even better when investment return is higher. Our example assumed a modest 3% return (net inflation). If the return were 6%, the pretax improvement of the scenarios would be:

Scenario	1	2	3
Pretax Improvement (20 years)	15.1%	3.6%	0%
(30 years)	21.1%	5.9%	0%

Summary
While the future is never certain, it is in your best interest to plan for it. You can usually start by assuming things will remain relatively the same. So put those taxes off as long as you can.

If you have questions or comments, please contact us at Dean & Company.