If you aren’t going to spend your retirement money today, why not benefit from tax-deferred savings. You may be one of those people who enjoy putting things off, especially those that you consider to be burdensome. Let’s examine what non-tax deferred savings looks like.
Long and Short-Term Gains
Many people do not understand that short-term gains are taxed at their marginal tax rate which could be as high as 39.6%. When you invest in a certificate of deposit (CD) that matures in less than a year, it is taxed at your marginal tax rate. Let’s look at what happens when you buy a $1,000 CD at 5% using the worst case scenario of 39.6%. You make $50, but lose $20 to tax and keep $30. However, if that 5% was made say in 367 days, you would be taxed at 20%, the current long-term capital gains rate. You will lose $10 to tax and keep $40.
Traditional Tax-Deferred Savings
Tax deferral is the process of delaying (but not necessarily eliminating) the payment of income taxes on income you earn in the current year. One of the best ways to accumulate funds for retirement is to use tax-deferred savings vehicles. Tax deferral can be beneficial because:
- The money you would have spent on taxes remains invested.
- You can accumulate more dollars in your accounts due to compounding. (For more, see: How Compounding Benefits Your Retirement Savings.)
- You may be in a lower tax bracket when you make withdrawals from your accounts (for example, when you're retired).
Compounding means that your earnings become part of your underlying investment and they in turn earn interest. In the early years of an investment, the benefit of compounding may not be that significant. But as the years go by, the long-term boost to your total return can be dramatic.
Contributions for 2016 to the following types of plans grow tax deferred, but you'll owe income taxes when you make a withdrawal:
Traditional IRAs: You can contribute up to $5,500 to an IRA and individuals age 50 and older can contribute an additional $1,000. Depending upon your income and whether you're covered by an employer-sponsored retirement plan, you may or may not be able to deduct your contributions to a traditional IRA, but your contributions always grow tax deferred.
SIMPLE IRAs and SEP IRAs: You can contribute up to $12,500 to one of these plans. Individuals age 50 and older can contribute an additional $3,000. An employer that adopts a SEP IRA may make contributions on your behalf as high as $53,000.
Employer-sponsored plans (401(k)s, 403(b)s and 457 plans): You can contribute up to $18,000 to one of these plans. Individuals age 50 and older can contribute an additional $6,000. Your employer may boost this up to as high as $53,000 through matching contributions and profit-sharing contributions.
Another opportunity to save is the Roth IRA account. Your contributions are made with after-tax dollars, but they will grow tax deferred and qualified distributions will be tax free when you withdraw them. Roth IRAs are open only to individuals with incomes below certain limits. The amount you can contribute is the same as for traditional IRAs. Total combined contributions to Roth and traditional IRAs can't exceed $5,000 each year for individuals under age 50.
If your employer offers a Roth 401(k) or Roth 403(b) you can contribute up to $18,000 and those 50 and older can contribute an additional $6,000.
Taxes Make a Big Difference
Let's assume two people invest $5,000 every year for 30 years and earn 7% annually. One invests in a tax-deferred account and the other person in a taxable account. Assuming a marginal tax rate of 25%, in 30 years the tax-deferred account will be worth $505,365.27, while the taxable account will be worth $365,022.18. Assuming today’s max rate of 39.6% rate for a high income earner, the taxable account would be worth even less, $303,665.77. There are also other options that should be considered which are outside the scope of this article.
If the tax-deferred account was a Roth account, the withdrawals would not be taxed. However, if it was a traditional IRA the money would be taxed at the then prevailing rate. That rate might be higher or lower than their rate today. (For more from this author, see: How Tax Refunds Can Hurt Your Retirement.)
As future tax rates could be higher or lower, I believe in diversifying your accounts from a tax perspective. Moreover, as you get older things like inflation, health expenses and the deductibility of certain items make you more financially vulnerable. It is wise to provide options for the future.
While taxes are important, your investment decisions shouldn't be driven solely by tax considerations. You should factor in things like potential risk, the expected rate of return and the quality of the investment. This issue is ripe for collaboration between you, your tax professional and your certified financial planner.
(For more from this author, see: The Pains and Gains of Retirement Planning.)
(1) This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. (2) The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. (3) Examples used are hypothetical and for illustrative purposes only. Your results may vary.