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 The money is only taxed when it is finally withdrawn.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 Therefore, your $10,000 investment will grow tax free in the account until it is withdrawn.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. How do I calculate my effective tax rate using Excel?

    Find out how to calculate your effective tax rate using Microsoft Excel, what income tax rates to apply to your earned income ...
  2. What is the difference between income tax and capital gains tax?

    Understand the difference between a person's income tax and his capital gains tax. Learn when a person needs to pay taxes ...
  3. What is the optimal level of withholding tax to enter on my W-4?

    Learn about the federal governments payroll tax withholding scheme and how it affects your paycheck, including how to determine ...
  4. How can I calculate my withholding tax rate?

    Find out how to use the IRS website to estimate your proper withholding tax rate, and what you need to do if your information ...
RELATED TERMS
  1. Tax Deductible Interest

    A borrowing expense that a taxpayer can claim on a federal or ...
  2. Current Service Benefit

    The amount of pension benefit accrued by an employee who had ...
  3. Self Invested Personal Pension (SIPP)

    A tax-efficient retirement savings account available in Great ...
  4. Senior Move Manager

    Senior move managers (SMMs) help seniors downsize and relocate ...
  5. Medigap

    Also called Medicare Supplement Insurance, Medigap is health ...
  6. Elder Care

    Elder care, sometimes called elderly care, refers to services ...

You May Also Like

Related Articles
  1. Mutual Funds & ETFs

    Top 7 ETFs Designed for Retirement Income

  2. Professionals

    5 Signs That You Have a Lousy 401(k) ...

  3. Entrepreneurship

    Why Small Business Owners Need Financial ...

  4. Mutual Funds & ETFs

    Top Commodities ETFs for Your Retirement ...

  5. Professionals

    How the Robo-Advisors Differ (& How ...

Trading Center