In the last post, I covered how fees can eat into your returns, especially over the long-term. Today, I’ll cover contributions to retirement accounts.
With retirement savings, we have to dig a little deeper because of the different options and the different types of accounts. The biggest differences between retirement accounts are whether your contributions are before or after taxes. Roth IRA, Roth TSP, Roth 401(k), and Roth 403(b) accounts are all retirement accounts with after tax contributions, which means you pay income taxes on your contributions in the year you contribute to the retirement accounts, BUT you don’t have to pay any taxes on the withdrawals during retirement. Traditional IRA, TSP, 401(k), and 403(b) accounts are all retirement accounts with pretax contributions, which means you do not pay income taxes on your contributions in the year you contribute to the retirement accounts, so you DO pay taxes on your withdrawals during retirement. You do have limitations for contributing to IRAs. There are income limits for contributing to Roth IRAs, and income limits for the ability to deduct traditional IRA contributions on your taxes.
So which type of retirement accounts should you contribute to?
This is where you may need to talk to a tax professional. I am not a tax professional, but I can discuss why we contribute to our retirement accounts in the way we do. When deciding on where we will make retirement contributions, I consider a few things: our current tax bracket, what I think our potential future tax brackets will be when we start withdrawing from retirement accounts in 20-30 years, and how much we will have saved for retirement. The biggest factor of the three is where I think future tax brackets will be in 20-30 years. For me, I try to look at it realistically. Do I think taxes will be higher, lower, or the same in 25 years? I think they will be the same or higher. I come to this conclusion because of our continually growing national debt, and our government’s propensity to continually spend more money than it receives in tax revenue with annual spending deficits. Could I be wrong? Yes, absolutely, but I’d rather take a more conservative approach. Conservatively, this thought process leads me to maximize retirement contributions into Roth accounts, specifically Roth IRAs and Roth TSP. Part of our planning is to also consider military retirement, since it will provide a minimum amount of taxable income during retirement. Even if taxes stay the same, I’ll show you how you’ll pay a lot more in taxes when contributing to traditional retirement accounts instead of Roth retirement accounts.
Taxes, Taxes, Taxes
I know I just lost about half of my readers, but stick with me for a couple of minutes. We will go through one quick example to cover why I think that using Roth retirement accounts have better tax advantages. Let’s assume you save $6,000 per year, which is the maximum contribution to a Roth IRA (it goes up to $7,000 if you are 50 or older), for 30 years and get a 7% growth rate on your money. I’m 38 right now, so that would put me at 68 years old when I start withdrawing from my Roth IRA. After 30 years, when I’m 68, my Roth IRA will have $606,438. If I withdraw $25,000 every year in retirement and the growth rate on my retirement accounts drops to 4%, I’ll still have over $500,000 after 30 years of retirement withdrawals, at 98 years old. If I increase my withdrawals to $30,000, I’ll still have over $200,000 after 30 years of withdrawals.
| Years of Retirement Contributions | Annual Contribution | Growth Rate | Nest Egg At Retirement | Tax Rate | Taxes Paid |
| 30 | $6,000 | 7% | $606,438 | 12% | $24,545 |
| 30 | $6,000 | 7% | $606,438 | 20% | $45,000 |
Now let’s look at taxes using the example above. The table above shows how your retirement savings will grow and how you’ll pay in taxes if you contribute to Roth retirement accounts. If you contribute $6,000 to Roth retirement accounts for 30 years at a 20% tax rate, you’ll pay $45,000 in income taxes when you contribute. If you are in the 12% tax bracket, you’ll pay $24,545 in taxes when you contribute to your retirement. However, during retirement, even if you’re only paying a 10% tax rate, you’ll pay $75,000 in taxes if you contribute to traditional retirement plans with a $25,000 annual withdrawal rate, and $90,000 in taxes at a $30,000 annual withdrawal rate, as shown in the table below
| Years of Retirement Withdrawals | Starting Retirement Nest Egg | Growth Rate | Annual Withdrawal | Tax Rate | Taxes Paid | Remaining Nest Egg |
| 30 | $606,438 | 4% | $25,000 | 10% | $75,000 | $508,711 |
| 30 | $606,438 | 4% | $30,000 | 10% | $90,000 | $217,069 |
Conservatively, this thought process leads me to maximize retirement contributions into Roth accounts, specifically Roth IRAs and Roth TSP. Part of our planning is to also consider military retirement, since it will provide a minimum amount of taxable income during retirement.
Close to or already retired?
With all of that being said, for those nearing or in retirement without pensions, you may want to consider different asset allocations. One consideration would be to keep 3-5 years of expenses in a high-yield savings account or in CDs. This way, if there is a major downturn in the stock market, like we just had, then you’re not selling depreciated assets, and you can give them time to recover before selling.
Wrap Up
Unless you are retired or near retirement (less than 5 years away), you should probably have a much heavier allocation of your retirement savings towards stocks than bonds. And that money should be invested in low-cost mutual funds or ETFs. If you’re investing in higher fee funds, your long term investing returns could be significantly lower.
If you want to run some of your own numbers for growing your nest egg check out the savings and retirement calculators on ‘Rat Race Off Ramp’:
Retirement Nest Egg Calculator
Retirement Savings Calculator
Retirement Age Calculator
Savings Calculator
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