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.
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 greater on the tax-deferred investment earning 6 percent per year versus an investment of the same value in a taxable account of a worker in the 30 percent tax bracket.
Funding tax-deferred retirement accounts saves money on the tax bill up front, and lets them grow the contribution tax-free until age 70.5, when they have to start taking money out. Spending down emergency savings or securing a low-interest home equity loan to fund 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 that occur before the age of 59.5. The earnings on the investment are never taxed, whereas the principal and the growth are taxed in traditional accounts as funds are withdrawn.
In the years leading up to retirement, the Roth should play a big part in a retirement plan. If your client’s got a chunk of cash in a Roth, he or she can defer paying taxes on money in an IRA or a 401(k) long into retirement, but they have to fund it and they have to get started as soon as possible. After they retire, they should draw down the Roth IRA first. Pay the taxman later!