A:

One of the biggest and most often-touted advantages of putting money into a retirement account is the tax savings that come from income deferral. There is no doubt that this is a major benefit, but it is not the only factor you should consider when thinking about saving for your post-work years. In fact, the general consensus among investment advisors is that you should save as much as possible in preparation for the future.

When you contribute money to a tax-deferred retirement account, the money is deducted from your taxable income for the year in which the investment was made. The money is only taxed when it is finally withdrawn.

For example, if you have a yearly taxable income of $50,000 but you put $10,000 of that money into a tax-deductible retirement account, only $40,000 of your income will be subject to income tax. Therefore, your $10,000 investment will grow tax free in the account until it is withdrawn. The benefit of tax-deferred accounts lies in the assumption that a person's tax burden will be lower in his or her retirement years than during his or her income-generating years. By deferring income until their personal income tax rates decrease, those who invest in retirement accounts are able to lower their overall tax expense.

However, contribution limits on retirement accounts allow investors to defer taxes on only a set amount of income. As a result, some investors contribute only up to that contribution limit. If you have maxed out your tax deductible limits, however, you should not take that as an indication that you have done enough and should stop saving. Adequate retirement savings will ensure that you will be able to maintain an enjoyable lifestyle in the future and that you will have the resources necessary to deal with unforeseeable expenses. Therefore, any additional money that you save for retirement is worthwhile, even if your contributions are not tax deductible.

Not all the savings you have earmarked for retirement need to be placed in a retirement account, however. Tax-deductible accounts offer a limited range of investments - investing your money elsewhere offers additional investment opportunities. For example, the money you save beyond retirement contribution limits could be invested in real estate, such as a vacation home or a rental property. You could even invest the money in a side business. However, if these alternative forms of investment don't appeal to you, there is nothing wrong with putting more money into your retirement account. Through the "magic" of compounding, you can put yourself ahead of the game with every extra dollar you save.

To learn more, check out Fundamentals Of A Successful Savings Program, Retirement Planning Basics and Determining Your Post-Work Income.

RELATED FAQS

  1. What are the best free online calculators for calculating my taxable income?

    Find out where to locate the best online calculators to determine your taxable income and why it is important to know this ...
  2. In what instances does overhead qualify for certain tax allowances?

    Find out about instances in which overhead expenses qualify for tax allowances, including some common examples of tax-deductible ...
  3. How are write-offs recorded on my tax return?

    Find out how to document your write-offs when filing your tax return, including which forms you must complete for personal ...
  4. What is the difference between comprehensive income and gross income?

    Learn the specifics of both comprehensive income and gross income, how they are legally defined, and the primary difference ...
RELATED TERMS
  1. Dynamic Updating

    A method of determining how much to withdraw from retirement ...
  2. Possibility Of Failure (POF) Rates

    The likelihood that a retiree will run out of money prematurely ...
  3. Safe Withdrawal Rate (SWR) Method

    A method to determine how much retirees can withdraw from their ...
  4. Duty Free

    Goods that international travelers can purchase without paying ...
  5. Qualified Longevity Annuity Contract

    A Qualified Longevity Annuity Contract (QLAC) is a deferred annuity ...
  6. Mandatory Distribution

    The amount an individual must withdraw from certain types of ...

You May Also Like

Related Articles
  1. Professionals

    Is a Google Robo-Advisor on the Horizon?

  2. Savings

    Millennials' Money Habits: How to Help

  3. Investing

    Looking for Alternatives to Invest in ...

  4. Stock Analysis

    The Best Buy-and-Hold Stocks for Your ...

  5. Retirement

    How to Battle Inflation During Retirement

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!