How to Think About That Tax Deduction

Assuming you follow the rules, a Roth IRA or Roth 401(k) will give you tax-free growth—and it doesn’t get much better than that. But what about traditional 401(k) plans and IRAs, where you can get an initial tax deduction, but everything withdrawn in retirement is taxable as ordinary income?

Occasionally, you’ll hear so-called experts—who often have some other investment they’re peddling—criticize tax-deductible retirement accounts, arguing that people are setting themselves up for huge tax bills in retirement. That may be the case. But if you run the numbers, you find the initial tax savings frequently end up paying for the final tax bill. Indeed, a tax-deductible account can give you tax-free growth, just like a Roth (though, as you’ll discover in the next section, there’s a subtle difference that nerdy types might consider).

Imagine you saved $8,000 in your employer’s 401(k) plan and you’re in the 25% federal income tax bracket. Thanks to the $2,000 in initial tax savings, your out-of-pocket cost is $6,000. Over the next 30 years, your $8,000 grows fivefold—or 400%—to $40,000. At that point, you cash it out, paying 25% in taxes, equal to $10,000.

That $10,000 represents 400% growth on your initial $2,000 in tax savings. In effect, the tax deduction paid the final tax bill, leaving you with tax-free growth on your $6,000 out-of-pocket cost. What if your tax bracket is lower in retirement, which is often the case? In that scenario, you’ll have made out at Uncle Sam’s expense.

Still, if you fund tax-deductible retirement accounts, it’s worth keeping those embedded tax bills in mind as you approach retirement, so you have a better handle on the post-tax value of your retirement savings. The fact is, $10,000 in a tax-deductible retirement account will buy fewer groceries than $10,000 in a Roth.

Next: Further Nerdy Thoughts About That Tax Deduction

Previous: Tax-Deductible vs. Roth Accounts

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