The Common Money Mistake That Could Cost You Your Retirement

Are you making a simple investing mistake that could cost you thousands of dollars in lost retirement savings?

Based on looking at a lot of portfolios and reading your comments, many of you are.

The mistake is the result of what sounds like simple, clear, and irrefutable logic about savings and taxes. The logic, however, is wrong.

I’ve written about this error before, but I’d like to try and make it as simple as possible so you don’t screw it up.

The wrong way to save

The mistake is saving in a taxable brokerage account instead of an IRA, 401(k), or other tax-deferred retirement account.

The fallacious argument goes like this:

“I expect my federal income tax bracket in retirement to be 25%. The capital gains tax rate is 20%. When I withdraw from my 401(k), all my withdrawals will be taxed at 25%. Why would I pay 25% when I could choose to pay 20% instead?”

Here’s the same (still wrong!) argument in numbers. Let’s say I save $10,000 today and let it grow for 30 years at 5% per year, then withdraw it and pay the tax. We’ll see what happens if I use my IRA and compare that to a taxable account.

	IRA/401(k)	Taxable account
2013	$10,000	$10,000
2043 (pre-tax)	$43,219	$43,219
2043 (after tax)	$32,415	$36,576

 

Sure enough, after paying the appropriate tax (income or capital gains), you end up $2000 richer by using the taxable account.

(We’re ignoring interest and capital gains for this simplified example, but it wouldn’t change the result much.)

So why am I arguing against the taxable account and in favor of the IRA or 401(k)? Did I get hit on the head?

The right way to save

Here’s the problem: $10,000 in an IRA or 401(k) isn’t the same as $10,000 in a taxable account, because the money in the taxable account has already been taxed.

Put another way, it’s much easier to save $10,000 in a 401(k) than in a taxable account.

If you’re in the 25% income tax bracket and you have the means to save $10,000 in a taxable account, by simple arithmetic, you have the means to save $13,333 in a 401(k).

When you get paid $13,333, you owe $3333 in tax. Instead of forking that money over to Uncle Sam today, however, you can say, “No thanks, I’ll pay later,” and contribute the full amount to your 401(k).

And that’s a good move. It completely changes the result of the scenario above.

	IRA/401(k)	Taxable account
2013	$13,333	$10,000
2043 (pre-tax)	$57,624	$43,219
2043 (after tax	$43,218	$36,576

 

As you can see, using the IRA or 401(k) leaves you ahead by over $6500.

Save even more

But there’s more to it than that. People often confuse their tax bracket with their effective tax rate.

If you’re in the 25% income tax bracket, that doesn’t mean you’re paying 25% of your income in federal taxes. It just means that’s the rate you’ll pay on the next dollar you make.

Most of your income is taxed at a lower rate. It’s quite possible—typical, even—for a family in the 25% bracket to pay an effective tax rate of 10%.

And it’s the effective rate that will be applied to your IRA withdrawals, because they’ll end up mixed in with all your other income in retirement: part-time work, pension, Social Security.

If you’re in the 25% income tax bracket, however, your capital gains will be taxed at 20%, period.

So let’s compare again, this time using a 10% effective income tax rate.

	IRA/401(k)	Taxable account
2013	$13,333	$10,000
2043 (pre-tax)	$57,624	$43,219
2043 (after tax	$51,862	$36,576

 

The point of using a tax-deferred account is to avoid paying taxes when you’re taxed at the highest rate of your life (while you’re working) and instead pay them later, in retirement, when you’re taxed at a lower rate because you’re no longer working full-time at your peak salary.

Let’s look at one last scenario. Using Intuit’s Taxcaster tool, I created a hypothetical 65-year-old couple drawing a combined $60,000 a year in Social Security benefits and withdrawals from their savings.

Their effective tax rate is 4.6%, and their capital gains rate is zero. Surely, with no capital gains tax whatsoever, the taxable account has to come out ahead, right?

	IRA/401(k)	Taxable account
2013	$13,333	$10,000
2043 (pre-tax)	$57,624	$43,219
2043 (after tax	$54,973	$43,219

 

Not even close. If you have the opportunity not to pay 25% tax today so you can pay 4.6% tax later, take it.

And this isn’t a weird hypothetical, it’s typical: most US retirees pay very little federal tax.

The take home message: when saving for retirement, don’t use a taxable account when you still have room in your IRA, 401(k), or other tax-deferred account.

Matthew Amster-Burton is a personal finance columnist at Mint.com. His new book, Pretty Good Number One: An American Family Eats Tokyo, is available now. Find him on Twitter @Mint_Mamster.