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 your client can save enough to max out their 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 catch-up 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 your client has $1,000 and is in the 30 percent bracket for combined state and federal taxes. If they pay the tax now, they’ve got only $700 to save and grow for retirement. If their investment earns 6 percent interest per year, all the growth would be taxed as ordinary income at the 30 percent rate. Their earnings at 6 percent would equal an after-tax return of 4.2 percent.