Post-Retirement Tax Exemption for Investment Earnings

In yesterday’s post I extolled the virtues of the tax exemption in tax-favored retirement plans as the workhorse of retirement planning. Well, you say, that may be true for someone in his 30’s with plenty of time, but what about someone already in retirement? Doesn’t the miracle of pre-tax compounding of investment earnings cease once you’ve started to take distributions from your account? I respond, “No, Grasshopper, that tax exemption is the gift that keeps on giving.”

Consider the example of Ralph and Ed from Wednesday’s post, but let’s change the facts a bit. Instead of being in their 30’s, they are both age 67 and about to retire. They each have saved $6,000 from their final year’s salary. Ralph contributes his $6,000 to his employer’s 401(k) plan. Ed pays $1,800 of income tax on his $6,000 and puts the $4,200 balance in an ordinary taxable account. One more change to the facts. Both Ralph and Ed expect to be in the 30% tax bracket for the rest of their lives. Ralph expects to earn 7% (pre-tax) on his $6,000, and Ed expects to earn 7% pre-tax and net 5.3% after tax on his investment account. Each expects to live 29 years (good genes).

Here’s what the boys can expect to reap from the retirement planning they’re sowing. Using a financial calculator, Ed figures he can spend his $4,200 at the rate of $287 per year for the rest of his life. He’s already paid tax on the $4,200 and its investment earnings, so he gets to spend the whole thing. Fair enough.

What about Ralph, the wise one (the wide one)? Using the same financial calculator, he figures he will exhaust his $6,000 401(k) account at the rate of $489 per year. But he hasn’t paid tax on any of that yet. After paying a 30% income tax, Ralph expects to have $342 per year to spend. That’s 19% more than Ed. “How sweet it is!” thinks Ralph.

The point of this example is to illustrate that the chief tax benefit of tax-favored retirement accounts, their tax exemption, still has more work to do for you even after you have retired.

But wait! There’s more! What about after death? None of us really knows if there’s life after death, but I can report that there’s continued tax-exemption after death. Tax exemption is the gift that keeps on giving—to you, then to your spouse, and ultimately to your kids. That’s a subject for a future post.