Should My Retirement Savings Be Pretax or Posttax? (original) (raw)
While there’s no one-size-fits-all approach to retirement savings, financial advisors tend to recommend stashing 10% or more of your pre-tax income
Mallika Mitra
Written by
Contributor, Buy Side from WSJ
Mallika Mitra is a contributor to Buy Side from WSJ.
Updated September 13, 2024, 4:43 PM EDT
“I know I am supposed to save at least 10% of my income for retirement, but is that pretax or posttax?”
You’re correct that a general guideline is to save at least 10% of your income for retirement—and that the figure will look significantly different if you calculate it using your pre-tax income versus your posttax income.
By asking this question, you may already be ahead of many Americans: According to a recent survey from AARP, 20% of adults ages 50 and older have zero retirement savings and 61% worry they won’t have enough to support them once they hit retirement.
While there’s no one-size-fits-all approach to retirement savings, financial advisors tend to recommend stashing 10% or more of your pre-tax income for when you ditch your day job. Applying the 10% rule to your pre-tax income instead of your posttax income means you’ll be saving more money, which is necessary in the face of rising costs and longer post-work lives.
For example, if your income is 100,000andyousave10100,000 and you save 10% pretax for retirement, you’d set aside 100,000andyousave1010,000 annually. If you do that for 30 years you’d end up with around $1.8 million saved, assuming an average 10% rate of stock market return.
But while you’re earning 100,000,youmayactuallytakehomeaslittleas100,000, you may actually take home as little as 100,000,youmayactuallytakehomeaslittleas70,000 after taxes, as well as deductions for health and life insurance, says Erin Scannell, CEO of Heritage Wealth Advisors in Mercer Island, Wash. If you apply the 10% number to your after-tax income, you’d only be saving $7,000 a year for retirement.
That 3,000difference“mightnotsoundlikeabigdeal,butitendsupmakingaprettybigdifferenceovertime,”Scannellsays.Overthesame30years,3,000 difference “might not sound like a big deal, but it ends up making a pretty big difference over time,” Scannell says. Over the same 30 years, 3,000difference“mightnotsoundlikeabigdeal,butitendsupmakingaprettybigdifferenceovertime,”Scannellsays.Overthesame30years,7,000 would add up to closer to $1.2 million in savings.
“It’s like a snowball. The first time you start to roll it picks up some snow but not that much and then eventually, you have this big ball of snow and it picks up a lot of snow every time,” he says. “That’s how compound interest works.”
Why save 10% to 15% of your pre-tax income for retirement?
Many financial advisors will say to increase your retirement savings to 15%. For example, Fidelity Investments recommends setting aside 15% of that pre-tax income figure, including an employer match, to a retirement savings account like a 401(k).
Researchers at the firm analyzed national spending data to find that retirees typically need 55% to 80% of their preretirement income to maintain a similar lifestyle in their postwork years. To get there, Fidelity determined that around 45% retirement income will need to come from savings—with the rest coming from Social Security—and that setting aside 15% of your income each year from age 25 and 67 will get you there.
It’s important to note that the 15% rule assumes you start saving by your mid-twenties, and it may still not be enough to meet your retirement goals, for instance, if your healthcare costs are higher than anticipated or you want to travel a lot. So don’t stop there, says Catherine Valega, advisor and founder of Green Bee Advisory in Boston.
If you have access to a workplace retirement plan, she recommends contributing as much as possible to your 401(k), which allows for $23,000 in contributions in 2024. Of course, saving that much isn’t feasible for everyone. Valega says to invest what you can in a retirement savings account now and increase your savings rate by 1 percentage point each year.
Pick the right retirement account
It’s also important to consider where you’re saving it. You have several options for tax-advantaged accounts where you can set money aside.
A 401(k) employer savings plan allows you to put pre-tax money in the financial markets, which makes it easy to save pre-tax. The money grows tax-deferred and you pay Uncle Sam when you withdraw the funds in retirement. (Bonus: Many companies will match your contributions up to a certain amount). Individual retirement plans, orIRAs, are also tax deferred, while Roth IRAs and Roth 401(k)s allow you to fund the account with after-tax money and make withdrawals tax-free.
Meet the contributor
Mallika Mitra is a contributor to Buy Side from WSJ.