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
