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 that enjoy putting things off, especially those that you consider to be burdensome. Let’s examine what non-tax deferred savings looks like.
Long-term and short-term gains taxes
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 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 $1000 CD @ 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 taxed at 20%, the current long-term capital gains rate. You will lose $10 to tax and keep $40.
Traditional Tax-deferred savings: Tax me later
Tax deferral is the process of delaying (but not necessarily eliminating) until a future year 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
- 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 2015 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 $3000. 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, 457 plans)– You can contribute up to $18,000 to one of these plans; individuals age 50 and older can contribute an additional $6000. Your employer may boost this up to as high as $53,000 through matching contributions and profit sharing contributions.
Roth IRA Tax Me Now and Not Later
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.
Roth 401(k) – If your employer offers a Roth 401(k) and 403(b) you can contribute up to $18,000 plus $6000 if you 50 and over. and older can contribute an additional $6000.
Taxes make a big difference
Let’s assume two people invest $5,000 every year for a period of 30 years and earn 7% per year. One invests in a tax-deferred account and the other person on 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 other options that should consider which are outside the scope of this article. The Roth account would also be as the lower income, lower tax rate person $505,365.27.
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.
I believe in tax diversification. As future tax rates could be higher or lower, I believe in diversifying your accounts from a tax perspective. Moreover, as you get older to things like inflation, health expense and the deductibility of certain items makes you more financial 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 a collaboration between you, your tax professional and your CERTIFIED FINANCIAL PLANNER™ professional. If you need one, you can always contact us.
(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.