Photo by Micheile Henderson on Unsplash
One of my favorite tax breaks is contributing to a tax-deferred account, like a Traditional IRA, SEP-IRA or SIMPLE IRA. Contributions to these accounts lower your taxes when the contribution is made, and allow you to defer (postpone) owing taxes on those contributions until retirement.
But I fear in the past I’ve given this same advice on my blog without thoroughly explaining how and why this actually works.
In today’s post, I’d like to answer two questions:
How exactly does contributing to a retirement account mean lower taxes today?
Why does that matter if taxes are still owed later?
How Contributing to an IRA Means Lower Taxes Today
Tax-deferred accounts allow you to “lower” your taxable income. The IRS has you add up all your sources of income, like wages and self-employment income. This is your “Total Income” which your taxes owed will be based on. But wait! The IRS allows some nifty little adjustments to your income (it’s on line 8a below). If you look at Schedule 1 Parts I and II, you’ll see all the ways you can lower your income before determining how much you owe in taxes. These adjustments (along with the Standard Deduction) are subtracted from your Total Income to reach your Taxable Income--and an IRA contribution is one of them (it’s under Part II).
To illustrate, assume your total income in 2019 is $90,000 and you’re considering contributing $6,000 to a Traditional IRA. Assume you file your taxes jointly and you have no children or dependents. Here’s your taxes owed before and after the IRA contribution:
By contributing to a retirement plan, you’ve saved $719 in taxes.
How Saving Taxes Now Means Lower Taxes Later
Of course, taxes will need to be paid on those funds when they’re withdrawn--typically at retirement. So what’s the actual benefit here? Aren’t you just kicking tax payments down the road?
There are two main tax benefits at play when we consider tax-deferred accounts. First, when you invest your IRA funds into stocks, bonds or mutual funds, you don’t pay any taxes on those gains or interest earned until the funds are withdrawn. Even when stocks or mutual funds are sold and moved to a different investment, there are no taxes paid. This presents a tremendous advantage to using retirement accounts.
The second tax benefit requires a little more explanation. Most working professionals are in their peak earning years in their 40s, 50s and 60s. Peak earnings, of course, typically means peak tax rates as well. As you enter retirement, most American’s earnings go down. Why? The first most obvious reason is because you’re no longer working! Right away you stop paying 7.65% of your wage to payroll taxes (Social Security and Medicare taxes).
The second answer is not as obvious. Most Americans will qualify for Social Security income. The average Social Security check in January 2020 was $1,503. Assuming a spousal benefit on top of that, then a married couple might receive $2,250 Social Security on average, or $27,000 per year.
First off, no one pays taxes on more than 85% of their Social Security benefit, no matter how much additional income they make. So right off the bat, your taxable income is already lower in retirement by 15%.
Now let’s get back to your IRA. Assume you have been a diligent saver and now have $1,000,000 in your IRA, withdrawing $40,000 each year.
In this example, the taxes owed are clearly less than they were during your working years when earning $90k. This is because your income is lower, you pay nothing toward payroll taxes any longer, and you pay less taxes on your Social Security income overall.
What if your total income at retirement, between IRA withdrawals and Social Security, was still close to $90k? Your taxes would still be lower due to the advantages of lower Social Security income taxation. Also remember that $90k is more than most seniors need in retirement. Typically this is because you’re no longer saving for retirement, paying commuting costs, and your mortgage is paid off. Most retirees can comfortably get by on 60 to 80% of their pre-retirement income.
The bottom line is this: When you save for retirement during your higher earning years, you defer paying taxes on those savings until a future date. Once retired, you’re likely to be in a scenario where your taxable income is lower--due in part to the lower taxes owed on Social Security benefits, and also to the fact that we typically need less money in retirement anyway.
I hope you found this article helpful in detailing why tax-deferred retirement saving typically makes sense. Some circumstances may vary, but I believe most Americans will find themselves better off down the road by deferring taxes now and paying them later.