There are many advantages to using your 401k or IRA for future savings. These retirement tools are truly without compare in many respects. But if I had to pick out one attribute that shines above the rest, especially when compared to other ways to save, it’s the tax advantages.
This is well illustrated with a powerful example from an American College textbook* I was recently reading through.
Illustrating the Power of Retirement Accounts
To show the power of retirement account tax savings, let’s compare a $5,000 amount of money paid to you from your employer. Your employer gives you the option of two ways to receive it: As a cash payment, or a tax-deferred retirement account contribution.
Which would you pick? By assuming you earn $100,000 a year, have a marginal tax rate of 30%, and the money can earn 6% per year, here is how much you could save under these two payment options in one year (Sorry about the sloppy formatting):
Option 1: As a Cash Payment
$5,000 (Amount of payment)
- 1,500 (Minus taxes)
= 3,500 (Amount actually saved)
+ 210 (Plus 6% interest)
= 3,710 (Subtotal)
- 63 (Minus taxes on interest)
= $3,647 (Amount saved after one year)
Option 2: As a Retirement Account Contribution
$5,000(Amount contributed to your 401k or IRA)
+300 (Plus 6% interest)
=$5,300 (Amount saved after one year)
Clearly the tax advantage goes to Option 2. The text goes on to show that if this $5,000 benefit were to continue for 25 years, the final amounts saved under each option would be as follows:
Option 1
$166,240
Option 2
$207,047
You might remember that Option 2 isn’t tax free, just tax-deferred, meaning you’ll still need to pay taxes later. This is true, but there are two points to remember.
First, you’ve still received extra interest on your savings over time, since you weren’t taxed with the initial payment. Second, the expectation is that when you take the money out of your retirement account, you’ll be in a lower tax bracket since income tends to be lower in retirement.
3 Reasons Why IRAs are such a great idea
There are several powerful lessons to remember with this illustration. They show why using tax-deferred accounts, like IRAs and 401ks, is such a smart idea:
1. Interest is earned on the full amount
Remember, the same interest rate was used in both examples. The difference is Option 1 requires you to pay taxes first. It’s income. Only then can the money be invested. Option 2 doesn’t require the payment of taxes up front, so interest is earned on the full amount.
2. Never underestimate the tax benefits
Option 2 has the advantage of deferring (or postponing payment) of taxes until a later time. That’s great news. This means that the amount which would have gone to taxes can gain added interest in year one, and continue doing so in future years.
3. Investment returns are only half the story
So many investors focus on what their investment earns each year, that they have a hard time “seeing the forest for the trees.” Earnings are only part of the bigger picture. When you pay taxes on your earnings and how much you pay is just as important to consider.
I hope this simple illustration has been helpful. Many families are rightfully interested in only paying their fair share of taxes, and receiving any tax benefits they can along the way. Making pre-tax retirement contributions rather than simply putting cash in your pocket is a great way to pay less in taxes and build your wealth over time.
*Hopkins, Jamie and Littell, David. Planning for Retirement Needs. The American College Press, 2015. Print.