Broker Check

The Seed or the Harvest?

April 05, 2018

Would you rather pay tax on the seed or on the harvest?

So goes the explanation of saving pre-tax or post-tax. When you put money into a 401k or IRA, you are not taxed on the contribution (the seed), the money grows tax deferred (no tax while the money is in the account), and you pay tax on the seed AND the growth when you take the money out in retirement (the harvest).  The theory being that you will have less income in retirement and therefore a lower tax bracket on which to tax the distribution.  For example, you contribute $1.00 to a pre-tax savings account and you don’t pay tax on the $1.00.  Let’s assume that $1.00 grows to $3.00 by the time you retire, and you take the money out.  You pay tax on the $3.00.

After tax savings: ROTH and some life insurance products use after-tax dollars for the contribution. The seed is taxed.  The money grows tax deferred, same as pre-tax vehicles, but when you take the money out there is no tax on the growth.  Following the same example above: you invest $1.00 into a Roth IRA and receive no tax deduction for your contribution.  By retirement the account has grown to $3.00 and you take the money out and owe no tax.

  • Pre-tax Scenario: You get a tax deduction at today’s tax rates for $1.00 and pay tax on $3.00 at future tax rates.
  • After-tax Scenario: You pay tax on the $1.00 contribution at today’s tax rate but no tax on the $3.00 distribution when you retire.

We can see how the math works, BUT we have NO way of knowing where tax rates will be when you retire. With a nod to my colleagues in the tax advising business, there is a lack of tax effect clarity for those retiring in 2018, let alone 15-20 years from now!

One obvious point is that there is more value to after-tax savings for those with a 30 year time horizon than someone with a 5 year time horizon. The value of after-tax savings comes from the value of time and compound growth.

Another obvious point is regardless of the vehicle you contribute to, you must SAVE for the future. We know what the tax rates are today and the various restrictions on accounts.  We have NO idea what it is going to look like in the future.  Make a plan that works for you, execute the plan, evaluate annually and enjoy the future.

Finally, there are rules and regulations that go along with each savings vehicle. Account type choices may make it just right for you or a disaster.  Get some education about the pros and cons.

One more expression that I am beginning to enjoy more is, ‘The best time to plant a tree was 20 years ago. The second best time is today!’  I hear an awful lot of, ‘I wish I bought Apple stock 20 years ago or bought real estate a few years ago.’  To my feeble knowledge, time travel only exists in a TV Series, so there is NOTHING we can do about the past.  But, there are LOTS of alternatives to explore and take advantage of today.  Plan today and as above; execute, evaluate and enjoy!