If you have a dollar and you have to pay 8 cents in taxes to get access to it, versus if you have a dollar and you have to pay 18 cents on it in taxes, would it be better to pay those taxes early or late?
Trick question.
It doesn't matter whether you pay the taxes earlier or later, only the percentage difference matters.
If the tax brackets are identical, you would be indifferent. However, if they differ from one point in time to another, you would prefer to pay at the point in time when they are lower.
As a numerical example, say you have $1 today, and you can earn 10% a year on that dollar and your taxes are 10% when you take that money out. Would you rather pay taxes today, or next year? If you pay taxes today, you pay 10 cents and are left with 90 cents. In one year, that 90 cents will be worth 99 cents. Now, consider you let that dollar grow for the first year to $1.10 and then you pay taxes. You will still be left with 99 cents. This same math works compounding growth out 1 year or 50 years. Only if the taxes differ at points in time will you have a preference.
This formula is the essence of why the painful conversions and prepaying of taxes is so difficult to accomplish. It feels like you’ll have more money waiting to pay taxes and allowing your money to grow.
It's almost as if the government planned it this way to get us to pay more, but I don’t think they have the mojo. It's just how it worked out.
But, if you could do like I do and prepay for your haircuts for a year for a 20% discount, wouldn't you take the bet that you're going to need haircuts for another year and pocket the savings?
You or your loved ones are going to need money out of these retirement accounts just like you need haircuts, which tax bracket do you want to pay? Lower or higher?
Obviously, this is an oversimplification to illustrate my point. Check everything with your CPA before making any moves.
Thanks for taking a look!
Tom Gartner and Matt Bennis
This article represents opinions of the authors and not those of their firm and are subject to change from time to time, and do not constitute a recommendation to purchase and sale any security nor to engage in any particular investment or legal strategy. The information contained here has been obtained from sources believed to be reliable but cannot be guaranteed for accuracy.