Quizmaster Doug Hutchinson has come up with another great quiz that explores pre-tax and after-tax options for retirement investing. Let’s see what the math has to say.
Good luck!
Consider this scenario:
Your friend Peter is considering 2 investment options:
Option 1: Invest $3,000 in after-tax dollars to a retirement account (taxes are taken out of the contribution but the future value is not taxed)
Option 2: Invest $4,000 in pre-tax dollars to a retirement account (no taxes are taken out of the contribution but the future value is taxed)
Peter pays current and future taxes at a rate of 25%. Assume investment returns of 8% each year for the next 20 years for both of the options.
Only considering the factors above, which option would provide Peter with the highest value after 20 years?
Solution:
Calculate the value after 20 years for each option:
For Option 1, the future value is not taxed, so the calculation is straightforward:
Option 1 value after 20 years = $3,000 * (1.08)20 = $13,983
For Option 2, the future value is taxed which makes the calculation a little more complex:
Option 2 value after 20 years = $4,000 * [(1.08)20 (1 - 0.25)] = $13,983
In this particular scenario, Peter would be indifferent between Option 1 and Option 2 since both options result in the same value after 20 years. In this example, the future values of the after-tax and pre-tax options are equal because the current and future tax rates are equal. If this scenario was different and instead Peter's future tax rate was lower than his current tax rate, then the value of Option 2 would be greater since the future value would be taxed at a lower rate.
To learn more about planning for taxes in retirement, give us a call at 1-800-541-7774 or contact us here to get in touch with one of our Wealth Managers.
This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.
