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Meet Johnny…

Johnny makes $100,000 a year. He has decided to put $6,667 in to his 401K each year. This would  mean Johnny saves 6.67% for retirement.

Johnny’s friend, Deborah doesn’t have a 401k plan at her work. Deborah also makes $100,000 a year. Deborah decides she will put money in to a Roth IRA to build up her retirement nest egg. She throws $5,000 in to her Roth. Deborah is saving 5% of her income for retirement.

Now on to the discussion… 

Johnny’s $6,667 pre-tax contribution is the EXACT same as Deborah’s $5,000 post tax contribution (assuming they both are in 25% tax bracket). But would we say Johnny is investing 6.67% and Deborah only 5%?

This is something I never thought about before, but today I woke up and was like “WHOA!!!”. Have you ever considered calculating the PRE TAX percentage of your POST TAX contribution?




  1. This is something I’ve always wondered about!

    I’m saving 5% in my 401(k) and 5% in my Roth 401(k) plus I’m getting 4% from my employer plus any year-end bonus I get goes straight from my employer to my retirement fund. I’ve always thought that I’m saving 14+% but some is pre-tax, some is post-tax and some is free.

  2. It means that you should compare net and gross if you want apples to apples. So both Johnny and Deborah are saving 6.67% of gross income toward retirement.

    • I agree. I just had never considered the tax implications during all the years I’ve contributed to my Roth. As a percentage, I’ve been saving more than I intended as a result.

    • Yep. You’ve got to “add” the amount of taxes that Deborah is paying to the $5,000 she ends up with to have the real “cost” of what she’s investing. The biggest difference is in how the funds are handled afterwards.

  3. Being the novice financial planner for myself, How do I figure out the net and gross of a 401k and Roth IRA. I have one of each and wouldn’t mind knowing. Will the 401k post tax change over time?

    • Just need to figure out what your tax bracket is. Go here…..

      Once you figure out your tax bracket (I am in the 25%) then it’s a simple equation.

      Say I take my $5,000 Roth contribution and want to know what that amount equals BEFORE I paid taxes on it. Just do 5,000/(1-Tax Rate).

      In my case it would be 5,000/(1-0.25), which is the same as 5,000/.75. This equals $6,667.

      If you want to do the reverse simply multiply your Pretax income 6,667 by (1-Tax Rate). So you get 6,667*(1-0.25), or again, 6,667*0.75.

      Make sense?

  4. I don’t think I’ve ever made that distinction. Glad you brought this up. Like Shane said, seems like the best bet is to use gross or net exclusively for analyzing percentage of income to avoid saving more (the HORROR!) or less than intended.

    Side note, but hypothetical Johnny has a great name.

    • Neither had I before. I’ve maxed out my Roth IRA for five years now, and never once thought to myself my $5,000 contribution is really like a $6,667 contribution. Crazy!

  5. It probably means that if you are detailed enough to care about the difference between gross and net contributions, you don’t need to follow generic percentage-based savings advice! Find your own best contribution level based on your age, risk tolerance, post-retirement life expectancy, other (mid-term) goals, career path projection…

    • Yes and no. Haha. I’m in Washington, one of the few states without income tax so I forget about it frequently. And also, state income taxes vary so much it’s difficult to make that relatable to the masses.

      You’re right though, definitely another element to consider!

      • It could well be that state tax makes no difference, the effect of rates before and after-tax remaining constant.

  6. Nope. I never thought about it, but thanks. Though, in the end it should really matter, right? Like I state in my book, to be effective, a financial goal must be: measurable, such that it has a specific timeline and amount; purposeful, such that it is working towards something; and realistic, such that it is within our earning capacity. Saving 5% or 6.67% is completely arbitrary. Chapter 15 of my book talks about our misconception of retirement savings.

    • Hmmm, I don’t know if I totally agree. This example has a 1.67% discrepancy. If we take in to consideration state income taxes as well, it would widen the gap, moving it closer to 2.5%. I don’t know if saying 2.5% is arbitrary over 40 years of compounding. That can add up to be a HUGE chunk of change.

      People will just have to decide how much cash they want now, as opposed to how much they’ll want later.

      • Ok. I’m sorry. It’s arbitrary in the sense that you presented it, not in the sense that one person is saving more or less. I’m arguing that saving for a percentage shouldn’t necessarily be a primary goal. The critical look should be whether or not what is being saved is enough to create a financially independent retirement. Clearly, Johnny will come out on top if they both are saving in the same underlying investments AND both started and ended at the same time (although in your example you have Johnny saving pre-tax and Deborah post tax?).

        Still though, you have to take into account the tax savings now vs. tax savings later. Johhny pays less in taxes now (paying on $93,333) and Deborah is paying more (on $100,000). This feature only is why the question can’t be a matter of who is saving more, per se.

        Again, though, I love the question. It is very thought provoking. That, I am not arguing against.

        • If they are saving in the same investments, get the same rate of return, are in the same tax bracket, and start/finish at the same time, then Johnny is not the winner. It is a dead tie….

          If you are in the 25% tax bracket and contributed $100 to a Roth IRA and it grew 10% you would be able to withdraw $110 tax free (let’s ignore the 5 year rule etc). For the 401k if you contributed $133.33 (which works out to $100 pretax: $100 / 0.75) and it also grew 10% you would have $146.67, and after paying 25% taxes it would give you $110, which is the exact same as the Roth IRA.

          But I get what you’re saying, and you’re right, it shouldn’t be a flat percentage. It should be a specific goal (dollar amount) that we all work to meet.

  7. I always max out both, but my 403B first. I like the idea of using pretax dollars and atch it grow tax deferred. Although I contribute to a Roth IRA, I doubt that I will be in a higher tax bracket.

  8. I have dreams like that too. I max out my Roth and put 6% into my 401(k) plus a company match. I am putting something like 15% total.

  9. I always think about this. I always max whatever retirement is open to me (and, with my guidance, my husband does the same.) Like you, I don’t think my tax bracket will change much if the tax brackets themselves stay the same, but I happen to think sooner or later, all of the rates will have to go up. Regardless, I max my Roth 401k and not a pre-tax 401k principally because it presents a greater opportunity to put away money. If I were eligible to do a Roth IRA I would do that, too. The more the merrier!

  10. Ok. I referred back to your thread and read EVERY. LAST. COMMENT. haha. You, Larry, and Mark kept the conversation interesting. Anyway, apparently you are right. The following calculator computes exactly what your thread was discussing: So, you should go back and add this to your blog post.

    Would one actually have more money in retirement if choosing the 401k vs. Roth because of the company matching (i.e. the company matches the first 3% of contributions so at the end of the year you’ll have an extra $200 that will compound over time?), though probably not applicable in a t-401k vs. r-401k choice?

  11. I’ve been looking more into this whole Roth vs. tax-deferred question, and I have to admit at this point I’m coming down on the tax-deferred side myself. (Which is good for me, as I have over 20 times in my tIRA as in my Roth.) The 401(k) has the great advantages of a larger annual contribution limit (for 2012, $17K under 50/$22.5K over 50) versus the combined IRA limits of $5000/$6000 over 50), and also whatever employer match you may receive. The major disadvantages are the forced investment choices, often with high expense ratios, and the (often hidden) fees; however, with a government TSP you have that problem, and I myself have the advantages of having some low-cost Fidelity Spartan funds in our plan as well as the ability to shift funds from my 401(k) to my traditional IRA while I’m still working because I’m over 59.5.

    There is still the RMD issue over age 70.5 that may shift people into a higher bracket. For instance, if you have a $3 million IRA at 70.5, you have an RMD of $109.5K, which may or may not push up your bracket. And despite the convenient 70-80% of income replacement rule, if you have high out-of-pocket medical costs or you decide to finally take that trip around the world, your expenses may go up in retirement rather than down. Fortunately, retirees over age 59.5 who are hitting a higher bracket for any year have another strategy available with tax-deferred accounts, and that is to do a conversion from the tax-deferred to a Roth. You basically move enough to meet your expenses from the IRA into a Roth, and you move enough to cover the taxes into a tax-deferred account. The always invaluable Mike Piper covers this well in his book on retirement – the point being that in retirement you have more control over your tax brackets so that you have the advantages of the Roth when you need them.

    Overall, therefore, it sounds like the tax-deferred method is the way to go. I think if anything I will raise my contribution percentage in my 401(k) in the few years I have left before retirement.

  12. Here’s the real question: who will be better off?

    After 40 years, with a return of 7%, Johnny will have $1,330,000 in the account, and Deborah will have just under $1,000,000 (using round numbers). Let’s suppose they each decide to take 5% of their savings out per year, and they are both married.

    Deborah gets $50,000 per year tax-free.

    Johnny gets $66,500 per year pre-tax. Under the current tax laws, how much does he owe in tax? Because he’s married, he can claim the standard deduction (currently $11,900) and two personal exemptions ($3,800 each), for a total of $19,500 in tax-free income. For the remaining $45,000, he pays 15% (if the Bush tax cuts expire for all), for a tax of $6,750, leaving him with $59,750 in post-tax income, or 20% MORE than Deborah.

    How does this work? Because almost every personal finance blog I’ve read, including this one, uses very faulty assumptions. Yes, if the tax rate you pay now is the same as the one you will pay later, it’s a wash on whether or not you should invest in a Roth or a Traditional account. However, the tax you pay now is your MARGINAL rate – whatever rate you pay on your last dollar. The tax you’ll pay later is VARIABLE – 0% for the first $20K in our example, 15% for the next $70K, etc.

    So which is better in the end? It fully depends on your own opinions – your plans for your retirement years, your predictions on future tax rates, your trust of the government, etc. But at least make sure you’re using the proper numbers and analysis tools.

  13. In Australia it’s completely different. Our employers contribute 9% of your pay to our Super (so in this case the “total package” of both pay’s would be $109,000). From here, that $9000/year is then taxed at a flat 15% regardless of what tax bracket you’re in. So each year they’d have their Super (our 401K) increasing by $7,650. There are Super fee’s which can be big or small and of course the returns.

    The good thing is this is all mandatory and happens whether you pay attention or not so everyone always has at least SOMETHING for retirement. If you want to add more to it you can as well, however we don’t get “employer matching” or anything for it. Your contributions do only get taxed at 15% though, so if you’re making bank and earning $180,000+ (a tax bracket of 45%) then it makes a lot of sense to divert some of your income into Super as you’re saving 30% tax.

    As for thinking about things POST tax and PRE tax, I’ve always thought about things post tax because I compare it to my Real Hourly Wage. Well at least I started doing this after reading Your Money Or Your Life!

  14. The bad thing about the Roth IRA is the fact that her company is not matching any of her contributions 🙁 I rather go with the 401k for this reason

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