Don’t Let the Taxman Crash your Retirement
Nobody loves the taxman, and yet people pay him more than they have to. Instead of maximizing annual contributions to a traditional IRA or a 401(k) account, they pay the taxes now instead of deferring them until they retire. That’s a critical mistake.
Let’s pretend you can save enough to max out your 401(k) this year. Yes, it can seem impossible for some to cough up the $23,000 (standard maximum contribution of $17,500, plus the $5,500 catchup addition for workers over 50). But the key point is to illustrate the tax savings, which would be $5,750 in the 25 percent tax bracket. The tax savings will be less on the maximum contribution of $6,500 for an IRA in 2014, but still well worth taking advantage of.
Congress added the 401(k) to the tax code in 1978 to give Americans an incentive to save for retirement. Many workers over 50 aren’t saving, though. Workers between age 50 and 64 have only saved an average of $28,000 for retirement, says the National Institute on Retirement Security.
That’s a pretty sobering statistic, especially since saving in tax-deferred accounts is so advantageous. Assume you’ve got $1,000 and you’re in the 30 percent bracket for combined state and federal taxes. If you pay the tax now, you’ve got only $700 to save and grow for retirement. If your investment earns 6 percent interest per year, all the growth would be taxed as ordinary income at the 30 percent rate. Your earnings at 6 percent would equal an after-tax return of 4.2 percent.
Tax deferrals are the sexiest part of any strategy for retirement planning! Over a 12-year period, the return on the $1,000 would be 22.82 percent. Funding tax-deferred retirement accounts saves you money on the tax bill up front, and lets you grow the contribution tax-free until age 70.5, when you have to start taking money out. Spending down emergency savings or securing a low-interest home equity loan to fund your tax-deferred accounts in the years just before retirement is a wise move that many people don’t even consider.
The Roth IRA is sexy too! A Roth IRA allows an individual to contribute up to $6,500 in after-tax money in 2014 to fund the account. As with the traditional tax-deferred accounts, there are penalties for withdrawals before you reach age 59.5. The earnings on the investment are never taxed, whereas the principal and the growth are taxed in traditional accounts as you withdraw funds.
In the years leading up to retirement, the Roth should play a big part in your plans. If you’ve got a chunk of cash in your Roth, you can defer paying taxes on money in an IRA or a 401(k) long into retirement, but you have to fund it and you have to get started as soon as possible. After you retire, draw down your Roth IRA first! Pay the taxman later!
Roger Roemmich is a certified accountant, financial planner and long-term care professional. He recently published his retirement assistance guide, “Don’t Eat Dog Food When You’re Old.”