Contributing more to tax-deferred accounts is a straightforward way to boost your wealth. It’s difficult to come up with the funds to increase your contributions up to the government allowable limit each year, but putting away anything less than the maximum is giving up a significant tax break. Before you forego this opportunity to grow your nest egg faster, here are a few reasons tax-deferral is a sure way to improve your retirement finances.
You’re likely to drop into a lower tax bracket in retirement. Traditional 401(k)s and IRAs allow you to defer paying income tax on the amount you deposit in the account until the money is withdrawn from the account. Ideally, 401(k)s and IRAs allow you to defer paying income tax on your savings during your prime earning years when you are in a high tax bracket, and then pay a lower tax rate on the money when you withdraw it from the account in retirement because you have a smaller income then. In this case, saving in a retirement account allows you to lower your lifetime tax bill.
Don’t overestimate the taxes you will pay in retirement. Some people want to keep money out of tax-deferred accounts because they don’t want to be in a higher tax bracket in retirement than when they’re working. While that’s understandable, you would need to accumulate a substantial amount of wealth in retirement accounts in order to jump into a higher tax bracket because tax brackets are continually adjusted for inflation.
Even if your retirement tax rate stays the same, you won’t have to pay that rate on every dollar you withdraw. Our progressive tax rates guarantee that not every dollar you earn is taxed at your highest marginal tax rate. Part of your income is taxed at a lower rate. Every dollar you put in a retirement account reduces taxes by the highest tax rate you pay, but not every dollar you withdraw in retirement will be taxed at the highest rate because you need to fill the lower tax brackets first. And when you are no longer working, much of your money that is withdrawn will fill out the lower brackets.
You might not spend your entire nest egg in your lifetime. If you have saved enough in an IRA to worry about higher tax brackets, there’s also the possibility that you could end up leaving a sizable nest egg to your heirs. The money will then be taxed when your heirs withdraw it at their income tax rate, and you might not pay taxes on it at all. While you are sticking your heirs with the tax bill, they are still likely to be thankful for the windfall.
A retirement account can lower your income so you qualify for tax deductions. Many tax breaks are phased out for high earners. For those who are close to the margins, lowering your adjusted gross income by contributing to retirement accounts can be an incredibly profitable move. When you drop to a low enough income level you become eligible to take advantage of other tax deductions.
Avoiding annual taxes for decades is powerful. Money taken out of retirement accounts will be taxed at ordinary income tax rates, but avoiding taxes each and every year on gains and dividends will help your account balance to grow faster. Given sufficient time, this yearly tax savings will eventually outweigh the benefit of preferential tax treatment on investment gains in taxable accounts.
It’s more difficult to spend money in retirement accounts. While there are many ways to get around the early withdrawal penalties, having money in a retirement account still adds enough of an obstacle to make you think twice before blowing it on any impulse purchases. When money is in a retirement account, it’s acts as a barrier for unwise purchases, helping you keep more for your future self.
David Ning is the founder of MoneyNing.com .
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