There are a number of ways to save and invest for retirement with an assist from Uncle Sam. These include 401(k) workplace retirement plans, IRA accounts, and others. Though there are some subtle differences between them, they are all fantastic deals. You should invest as much as you possibly can into such accounts and be sure to avoid making early withdrawals from them.
What makes these plans such a great deal? The answer is tax deferral. The tax on investment gains that would normally have to be paid immediately are deferred until money comes out of the account.
Many people ask why tax-deferred investments offer such a powerful advantage when, in the end, they must still pay the tax. How is the government helping me if it merely puts off collecting the tax until later? Think of it as an interest-free loan to supercharge your investments. The government is saying, in essence, “Keep and invest the money you would normally pay us. Then, when you have used that money to make a lot more, we will take our cut.”
It is easy to underestimate how big an advantage this can really be. Here is an example: Two 30-year-old savers each begin to put away $1,000 per month and continue to do so until they turn 70. One of them puts the money into a tax-deferred retirement vehicle. The other simply puts it into a taxable account. They both earn an average 8 percent annually on their investments and they are both in the 25 percent tax bracket throughout. The fully taxable account will grow to $1,857,144 and all the taxes will have already been paid. The tax-deferred retirement account will have grown to $3,108,678 (in part because of the growth of all that money that was not taken away in taxes), and will now finally be taxed. After paying the tax, this investor will have $2,451,509. Notwithstanding the big tax bill at the end, he has over half a million dollars more than one who failed to take the benefit of tax deferral.
For most people, the advantage inherent in the tax-deferred plans is going to be even greater. For one thing, many people are in a lower tax bracket at age 70 than they were at age 30. Investing in such accounts while working and waiting to take withdrawals during retirement may well result in the money being taxed at a lower rate. More in your control, though, is the ability to choose when to withdraw the money to lessen the tax bite. While the government requires you to take a minimum annual distribution from these accounts when you turn 70 ½, withdrawals above that minimum can be carefully planned to occur in years of low earnings.
A group of tax-advantaged retirement plans named after Senator William V. Roth Jr., including the Roth IRA, use a different tax methodology but ultimately offer similar advantages. While after-tax dollars are invested initially, Roth accounts are not taxed when the money comes out. Whether a traditional tax-deferred account or a Roth solution will ultimately bring the investor more money depends on future rates of return and taxation — things that cannot be known with certainty in advance. As a result, many wise professionals advise using a combination of both.
The important thing is to take the fullest possible advantage of tax-deferred retirement accounts. Fund them to the maximum allowed or, if money is tight, the most you can possibly afford. Whether it is a 401(k) or 403(b) plan at your workplace, an SEP or SIMPLE IRA for the self-employed, or an IRA or Roth IRA that you manage yourself, try to maximize your contribution each year. It’s just too good a deal to pass up!