"Because then that money is mine." Amber Pawlik



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Why I Use After Tax Money for My Retirement Account

Several years ago, I was a new professional who was faced with a decision: put my retirement money in before tax or after tax accounts. Being a data analyst at heart, I crunched the numbers.

(Before I go on, of course, I am not a financial expert. I'm just a lady who had to make a decision a while ago. Take this advice for what it is: free.)

Below is a chart comparison of the two plans. In both, $100 is contributed to a plan and allowed to grow for 10 years. In the "Before Tax" plan, all $100 is contributed and allowed to grow. In the "After Tax" plan, a 20% tax is applied to the money initially. Thus $80 is allowed to grow. Here is how they would grow (at 4% growth per year):

Year

Before Tax

After Tax (20% tax)

1

 $         100.00

 $    80.00

2

 $         104.00

 $    83.20

3

 $         108.16

 $    86.53

4

 $         112.49

 $    89.99

5

 $         116.99

 $    93.59

6

 $         121.67

 $    97.33

7

 $         126.53

 $  101.23

8

 $         131.59

 $  105.27

9

 $         136.86

 $  109.49

10

 $         142.33

 $  113.86

 

Now, here is the fun part: how the taxes get taken out at the end of 10 years. I kept the same 20% tax rate at the end:

Year

Before Tax

After Tax

1

 $         100.00

 $    80.00

2

 $         104.00

 $    83.20

3

 $         108.16

 $    86.53

4

 $         112.49

 $    89.99

5

 $         116.99

 $    93.59

6

 $         121.67

 $    97.33

7

 $         126.53

 $  101.23

8

 $         131.59

 $  105.27

9

 $         136.86

 $  109.49

10

 $         142.33

 $  113.86

Taxes:

 $           28.47

 $       6.77

Total:

 $         113.86

 $  107.09

 

The taxes in the Before Tax plan apply to the full $142.33. Thus $28.47 is swiped and $113.86 is left. In the After Tax plan, only the earnings are taxed. The earnings were $33.86. Twenty percent of this is swiped, which is $6.77, leaving $107.09.

First, I would like you to marvel at something. Had the earnings in the After Tax plan not been taxed, the end total of both plans would have been identical. Both would have been $113.86. Further, notice in the Before Tax plan, $28.47 is paid in taxes while in the After Tax plan, $26.77 is paid in taxes. You would get the same amount in the end, but the government would get paid more. You would be putting your money into the Before Tax plan, letting it earn and grow more so the government could benefit.

But unfortunately, the earnings in the After Tax plan are taxed and thus, in the end, you earn less on the After Tax plan. I suspect that the earnings are taxed partially as an incentive for people to put money in the Before Tax plan, which raises more in tax revenue.

So, if the Before Tax plan makes more, why would I choose the After Tax plan? Because then that money is mine.

Now, this is the part that involves law and tax code, and I definitely encourage you to fact check me and know your own plan. But this is how all of this works to the best of my knowledge:

The After Tax money cannot be taxed again. More importantly, as best I have read, that money cannot be penalized should the money be taken out early. The Before Tax money can carry a 10% penalty, on top of taxes, if money is withdrawn early. Here are the numbers if you withdraw early (using the 10 year mark again). Note: This assumes the earnings on the After Tax money is penalized, a point of which I am not sure of:

Year

Before Tax

After Tax

Total:

 $         113.86

 $  107.09

After Penalty:

 $         102.48

 $  104.38

 

Why would I want to withdraw early? Doesn't everyone know that only irresponsible people withdraw early? Spare me the Suzy Orman lectures. I'm good with money, particularly with long term money. Here is a reason for early withdrawal: the fact that the economy keeps tanking and stocks keep taking hit after hit. Keeping money in stocks is not necessarily wise. With negative earnings, there is strong reason to move your money elsewhere.

As for early withdrawal on after tax money, I did an experiment to see how it works. I took $100 out of my retirement account. I wanted to see how much would get taxed. My experiment is not over as I have not filed taxes for this. But, initially, my retirement account docked me a very small portion of the $100, leaving me with most of my money. I would have preferred it if they took the money from the direct after tax direct contributions at first, leaving me with 100% of my money. But most retirement accounts prorate the withdrawal, taking it from part non-taxable portions and part taxable. I called to find out how this was calculated. For my account, I have an amount labeled "Nontaxable." These are my direct after tax contributions. They prorate this with my after tax direct contributions and earnings, which was called "after tax contributions." I also have company match contributions. If I take more than the "after tax contributions," that portion would get taxed and penalized. But, withdrawing up to the "after tax contribution" amount resulted only in taxing the prorated after tax contribution earnings, not the company match money.

Note: In my calculations, it doesn't seem like the 10% penalty was applied to the prorated after tax earnings. But, the amount is really so small that it may be hard to tell. And I will get more information when I file with the IRS. Perhaps if they tax me slightly more than the retirement account initially took, I will know there was a penalty applied.

As far as the earnings being taxed, the earnings were so abysmal that it pretty much didn't even matter that they were taxed. And those were earnings over several years.

There are of course many variables to consider in figuring out what plan is best for you. Some argue that if you withdraw when you are over 60, your tax rate may be lower, so you will profit more on the Before Tax plan. This assumes that you will make less money in retirement so you will be in a lower tax bracket. I have no hopes or expectations that taxes will be lower for me later, even if in a lower income tax bracket, due to the unpredictability of tax rates. The rate of growth also matters. The better the rate of growth, the Before Tax plan does better. I would also like to add that the age at which the government decides you are allowed to have access to your money, free of penalty, can also change, and probably will only increase.

In summary, if you're a purist who knows you will not be taking your money out of your account until retirement age; believe the market will do well; and think your tax rates will stay the same or go down, the Before Tax plan is probably for you. If you want more flexibility with your money; want to hedge against risk that the market will do poorly; and don't like being told when you are allowed access to your money, the After Tax Plan may be for you.

For me, it is the After Tax plan.

Amber Pawlik
December 9, 2011


On ‘Demand Side’ Economics: Why Spending Cannot Improve the Economy but Freedom Can
Amber Pawlik
This article seeks to explain as clear as possible one of the most intellectually difficult economic concepts to grasp: how inflation will destroy an economy. It is meant to give answers to the economics questions many people have today. It covers the basics of economics and then argues against the long held belief, originated by John Maynard Keynes, that stimulus money will jumpstart an economy. It can be considered an Economics 101 and 201 course.

This article is protected under the US Copyright Act of 1976. No part may be copied.

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