How Retirement Plans Help You Save on Taxes
Besides helping you build income for your retirement, many retirement plans offer the added benefit of sheltering your money from taxes. Nearly all plans build tax-deferred value, and some allow you to shelter your current income as well.
Tax-deferred means that the earnings that build up in your retirement plan are not taxed, as in other kinds of investments. Your earnings are free from taxation while they are in the plan. Once you draw them out, either at retirement or before, your earnings from these plans may be subject to taxes.
Even though you may have to pay taxes on your retirement plan earnings when you take them out, you may still pay less than if you had that income taxed as it was being earned. This is because you may have lower income in retirement, which may place you in a lower tax bracket.
In addition to savings from tax deferral, some plans allow you to contribute your income pre-tax, so you don't have to pay taxes on the money you contribute today (at least, not until you retire). With some plans, your contributions can be taken as deductions from your income for tax purposes.
There is a price to be paid for all this tax freedom, however. With most plans, any money you take out prior to retirement age can be taxed at a hefty percentage. There are also limitations to how much you can contribute to some plans, based on your income or employment status.
This chart shows you a comparison of three investment options: an after-tax, taxable investment, like a passbook savings account; an after-tax, tax-deferred vehicle, such as an annuity; and a pre-tax, tax-deferred plan, such as a 401(k) plan. As you can see, lessening the tax bite creates considerable extra capital for retirement.
Something more impressive happens when, instead of leaving a pre-determined amount of money to grow over time, you continue adding to it. The chart below shows the effect of investing $5,000 per year ($416.67 invested at the beginning of each month) into a pre-tax, tax-deferred account at various ages. The example uses an 8% interest rate, a rate that can be expected for retirement plans that invest in stocks or mutual funds. The earlier you begin investing, the more rapidly your funds will grow, because time and compounding of interest can make your investment base grow substantially.
By beginning your yearly investing at 25 instead of waiting until you're 35, you could potentially double your retirement wealth to nearly $1.5 million. Not bad for a little sacrifice in your early years out of college!
Even using the 6% rate from the first chart, your wealth would grow to $833,937 if you began investing at age 25.
As you can see from these illustrations, early and frequent investing along with tax advantages can prepare you financially for your later years, when you may not have the benefit of working. As the life expectancies of retirees continue to grow, their retirement income needs grow, too. Taking advantage of these tax-sheltered investments makes it easier to meet one's retirement goals.
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