The funds you put into regular investment accounts represent after-tax money. Assume, for example, that a person in the 25 percent tax bracket earns an extra $1000 and is considering investing those funds. She will pay $250 in income taxes on the extra income, which leaves only $750 in after-tax money available to invest. Furthermore, all earnings from the invested funds are also subject to income taxes each year as they are accrued. Matters are much different when you invest in taxsheltered retirement accounts.
Your Contributions May Be Tax Deductible
Contributions may be “deductible” from your taxable income in the year the contributions are made. In this situation, you pay zero taxes on the contributed amount of income in the current year. This means that you are investing with pretax money, and the salary amount you defer, or contribute, to a tax-sheltered retirement account comes out of your earnings before income taxes are calculated. Thus, you gain an immediate elimination of part of your income tax liability for the current year. The advantage of using tax-deductible contributions is illustrated in Table 17.2. The maximum contribution varies (discussed later) depending upon the type of taxsheltered account you are using.
Your Earnings Are Tax Deferred
Income earned on funds in tax-sheltered retirement accounts accumulates tax deferred. In other words, the individual does not have to pay income taxes on the earnings (interest, dividends, and capital gains) reinvested within the retirement account. A withdrawal is a removal of assets from an account.
You Can Accumulate More Money
You will have much more money when it is time to retire if you use tax-sheltered accounts for your investing instead of personal taxable accounts. The following examples assume that a person who pays combined federal and state income taxes at a 25 percent rate invests $3000 per year for 20 years in a diversified portfolio of stocks,
Your Contributions May Be Tax Deductible
Contributions may be “deductible” from your taxable income in the year the contributions are made. In this situation, you pay zero taxes on the contributed amount of income in the current year. This means that you are investing with pretax money, and the salary amount you defer, or contribute, to a tax-sheltered retirement account comes out of your earnings before income taxes are calculated. Thus, you gain an immediate elimination of part of your income tax liability for the current year. The advantage of using tax-deductible contributions is illustrated in Table 17.2. The maximum contribution varies (discussed later) depending upon the type of taxsheltered account you are using.
Your Earnings Are Tax Deferred
Income earned on funds in tax-sheltered retirement accounts accumulates tax deferred. In other words, the individual does not have to pay income taxes on the earnings (interest, dividends, and capital gains) reinvested within the retirement account. A withdrawal is a removal of assets from an account.
You Can Accumulate More Money
You will have much more money when it is time to retire if you use tax-sheltered accounts for your investing instead of personal taxable accounts. The following examples assume that a person who pays combined federal and state income taxes at a 25 percent rate invests $3000 per year for 20 years in a diversified portfolio of stocks,
bonds, and mutual funds that earns 8 percent annually. Calculations are from Appendix Table A.3.
Example 1—$110,357: Make Annual After-Tax Investments That Are Not Tax Sheltered The sum of $3000 in after-tax money is invested in a personal taxable account every year for 20 years. Because the 8 percent return is subject to annual income taxes, the return rate is effectively reduced to 6 percent [8 percent x (1 - 0.25)]. A $3000 annual investment for 20 years that earns 6 percent annually will grow to $110,357. The person has invested $60,000.
Example 2—$137,286: Make Annual After-Tax Investments That Are Tax Sheltered The sum of $3000 in after-tax money is invested in a taxsheltered account every year for 20 years. Because no income taxes are assessed on the interest, dividends, and capital gains while they accumulate, the return rate is 8 percent. A $3000 annual investment for 20 years that earns 8 percent annually will grow to $137,286. The person has invested $60,000.
Example 3—$137,286: Make Annual Pretax Investments That Are Tax Sheltered The $3000 in pretax money is invested in a tax-sheltered account every year for 20 years. Pretax contributions to retirement accounts reduce the current year’s income tax liability, so the investor saves $750 ($3000 0.25) in income taxes. Instead of the $750 going to the government, those dollars are used to reduce the amount the person had to invest. A $3000 annual investment for 20 years that earns 8 percent annually will grow to $137,286. Of the $60,000 invested, the person put in only $45,000 because $15,000 was money that would have otherwise gone to the IRS.
Example 4—$171,608: Make Annual Investments That Tax-Shelter Growth Plus Invest the Money That Would Have Gone to the IRS in Taxes The $3000 in pretax money is invested in a tax-sheltered account every year for 20 years. Pretax contributions to qualified accounts reduce the current year’s income tax liability, so the investor saves $750 ($3000 x 0.25) in income taxes. This time, however, the investor uses that $750 to help fund a larger contribution—$3750 instead of $3000. A $3750 annual investment for 20 years ($75,000 invested, although only $60,000 was the investor’s money and $15,000 was money that would have otherwise gone to the IRS) that earns 8 percent annually will grow to $171,608.
You Have Ownership and Portability
Portability means that upon termination of employment, an employee can keep his or her savings in a tax-sheltered account by transferring the retirement funds from the employer’s account to another account without penalty. Assets held in taxsheltered retirement accounts are always owned by the person who opened the account (once the person is vested, as discussed later).
Your Withdrawals Might Be Tax Free
Taxes may or may not be due in the future when withdrawals occur. IRS regulations permit tax-free withdrawals from only one type of retirement account, the Roth IRA, which is discussed later. Tax free means that withdrawals are never taxed.
Example 1—$110,357: Make Annual After-Tax Investments That Are Not Tax Sheltered The sum of $3000 in after-tax money is invested in a personal taxable account every year for 20 years. Because the 8 percent return is subject to annual income taxes, the return rate is effectively reduced to 6 percent [8 percent x (1 - 0.25)]. A $3000 annual investment for 20 years that earns 6 percent annually will grow to $110,357. The person has invested $60,000.
Example 2—$137,286: Make Annual After-Tax Investments That Are Tax Sheltered The sum of $3000 in after-tax money is invested in a taxsheltered account every year for 20 years. Because no income taxes are assessed on the interest, dividends, and capital gains while they accumulate, the return rate is 8 percent. A $3000 annual investment for 20 years that earns 8 percent annually will grow to $137,286. The person has invested $60,000.
Example 3—$137,286: Make Annual Pretax Investments That Are Tax Sheltered The $3000 in pretax money is invested in a tax-sheltered account every year for 20 years. Pretax contributions to retirement accounts reduce the current year’s income tax liability, so the investor saves $750 ($3000 0.25) in income taxes. Instead of the $750 going to the government, those dollars are used to reduce the amount the person had to invest. A $3000 annual investment for 20 years that earns 8 percent annually will grow to $137,286. Of the $60,000 invested, the person put in only $45,000 because $15,000 was money that would have otherwise gone to the IRS.
Example 4—$171,608: Make Annual Investments That Tax-Shelter Growth Plus Invest the Money That Would Have Gone to the IRS in Taxes The $3000 in pretax money is invested in a tax-sheltered account every year for 20 years. Pretax contributions to qualified accounts reduce the current year’s income tax liability, so the investor saves $750 ($3000 x 0.25) in income taxes. This time, however, the investor uses that $750 to help fund a larger contribution—$3750 instead of $3000. A $3750 annual investment for 20 years ($75,000 invested, although only $60,000 was the investor’s money and $15,000 was money that would have otherwise gone to the IRS) that earns 8 percent annually will grow to $171,608.
You Have Ownership and Portability
Portability means that upon termination of employment, an employee can keep his or her savings in a tax-sheltered account by transferring the retirement funds from the employer’s account to another account without penalty. Assets held in taxsheltered retirement accounts are always owned by the person who opened the account (once the person is vested, as discussed later).
Your Withdrawals Might Be Tax Free
Taxes may or may not be due in the future when withdrawals occur. IRS regulations permit tax-free withdrawals from only one type of retirement account, the Roth IRA, which is discussed later. Tax free means that withdrawals are never taxed.
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