Calculating a combined savings percentage when saving pre- and after-tax money

Question

This seems like a really simple and obvious question, but I can't find any previous questions on this site that directly address it. Perhaps it's so simple that people find it trivial.

Almost all basic retirement advice eventually discusses using your retirement savings percentage as a way of determining if you are more or less on track for retirement. Conceptually, this is really easy - amount saved divided by amount earned. However, when you are saving money in both pre-tax accounts [IRA, 401(k), 457(b)] and after-tax accounts [Roth IRA, Roth 401(k), Roth 457(b)], directly comparing the amount saved in each account is misleading.

So, what is the best way to calculate a combined savings percentage when using pre- and after-tax accounts? Or is a combined savings percentage meaningless in these cases?

Consider the following example:

    Category                              Percentage        Amount  
    Gross Yearly Pre-tax Income                             $50,000  
    Voluntary Pre-tax 457(b) Cont.        8%                $4,000  
    Mandatory Pre-tax Pension Cont.       7%                $3,500  
    Gross Yearly Taxable Income                             $42,500  
    Combined State and Fed. Taxes         21%               $8,925  
    Net Yearly Take-home Income                             $33,575  
    Voluntary After-tax Roth IRA Cont.                      $6,000  

I have been accounting for the after-tax Roth contribution by converting it to an equivalent amount of pre-tax money by dividing by (1 - tax rate). So for the example above (I apologize, I completely failed at formatting this as a pretty equation):

Combined Equivalent Pre-Tax Savings = 4000 + 6000/(1 - 0.21) = $11,595

I would then calculate my savings percentage based on my gross yearly pre-tax income, as follows:

Savings Percentage = 100 * 11595/50000 = 23.2%

(Note that I am not counting my pension contribution in any way because even if I ever do get any money from it, it won't be proportional to what I put in.)

Is this correct/does this make sense? Is there a better way to calculate this percentage? Or is any combined pre-tax and after-tax savings percentage always going to be misleading?

Answer 1

There's no magic to the rules of thumb like 15%. It's just a reasonable amount to save in most cases, meaning you live conservatively on 85% of your income. If you can save more, then save more. If you can't save that much yet, then figure out how to increase your income or reduce expenses if you want to meet that goal.

I think it's fair to look at the equivalent pre-tax amount to make sure you're saving enough. If you put in that amount now, you'd have a larger balance but would have to pay tax.

For example, putting in $6,000 after tax is the same as putting in $7,549 before tax (assuming you'd also invest the tax savings). If it grows by X% between now and retirement, the $6,000 will become $6,000*(1+X) tax free, while the $7,549 will net you $7,549*(1+X)*(1-T) = 6,000 * (1+X), all else being equal.

The main assumption is that your tax bracket is the same at retirement. If you think you'll be in a lower tax bracket (remember that 401(k) withdrawals count as income for tax-bracketing purposes) in the future, then it's mathematically better to defer the tax rather than pay it now. But that's just optimizing, and no one knows how the tax laws will change over the next 30 years.