Do You Want to Pay Tax on the Seed or the Harvest?

Do you want to pay taxes on your retirement money when you first invest it, or on the larger amount that will hopefully accumulate by the time you retire?

I have posed this question before, in previous posts, but I want to get into more detail with some numbers to illustrate the answer to that question and to have you look at the big picture as you determine what to do about taxes on retirement money.

First, suppose you  have a bucket of wheat that you plant. Paying taxes on

screen-shot-2016-12-07-at-4-37-35-pm

the wheat seed before you plant it would seem to make more sense. After all, if you grow a good crop, as you hope you will, the yield off that bucket of wheat is going to be substantially more than what you originally started with in the bucket. So if you wait to pay taxes on the  harvest, that
number is going to be significant.

Just how much tax will you pay on the seed as compared to the harvest? 

Let’s do the calculations together on deferring taxes until retirement (or paying on the crop rather than the seed):

  • You work for 35 years.
  • You manage to save $1,200 a year for 35 years, which equals $42,000. 
  • This money will grow to be $441,000 in your 401(k) by the time you are ready to retire.
  • At retirement, you pull out $34,900 per year to live on for your 18 years of life expectancy.
  • But, assuming a 20 percent tax bracket, you pay $125,600 in taxes on that 441,000 over the 18 years.

Deferring taxes and paying them at retirement saved paying taxes on the $42,000 you initially invested, but because that initial seed made you a nice little crop of $441,000, you ended up paying much more in taxes than you would have on the $42,000 if you had just paid as you went  on the $1,200 you saved each year.  This shows how deferring taxes on compounding money makes no sense as it forces you to pay three times as much in taxes.

What about the argument that you will supposedly be in a lower tax bracket in retirement. This is a silly argument, especially if you have amassed almost a half a million in retirement assets. Of course you will not  be in a lower tax bracket because you are “older” or supposedly making less income. You will probably be in a higher tax bracket because your house will probably be paid off, you no longer have dependents you can claim, and you have that amazing $441,000 in retirement money. The IRS isn’t stupid, they’re going to come after you with more determination than they did when you were working and expect you to pay a lot more. In addition, we have not even addressed anything about how this $34,900 that you withdraw each year to live on in retirement forces your Social Security income to be subject to income tax as well — read about it here.

So, my advice:  Think carefully about following the herd when it comes to dumping money into a 401(k). When you have your head down, following the sheep in front of you, when all the others go over the cliff, you will likely go over with them. For more information on better ways to prepare for retirement, contact me for a no-cost consultation:  peter@moneymastery.com.