Everyone knows they should be saving for retirement. However, you may not realize how beneficial your retirement accounts are in regards to you current tax status.
The basic principle behind retirement accounts saving you money is that most of them are funded with pre-tax dollars and grow tax-free. What exactly does this mean? First, you reduce your taxable income by whatever amount you deposit in your retirement accounts. Secondly, you avoid paying taxes on all of the growth within your retirement accounts, which is not possible in many other investments.
How much can you reduce your income by in retirement accounts? The answer is potentially a lot! For the year of 2005, you may invest between $14,000 and $18,000 in a 401(k) or 403(b) account depending on your age. You may also invest between $4,000 and $4,500 in a traditional or Roth IRA. However, a Roth IRA is not funded with pre-tax dollars, but does grow tax free.
For 2006, these amounts increase to $15,000-$20,000 in 401(k) and 403(b) accounts, and $4,000-$5,000 in IRA’s. Therefore, you can reduce your adjusted gross income by up to $25,000 in retirement accounts in 2006! Here is a simple example to illustrate how much can be saved in taxes by utilizing retirement accounts.
Example: In 2006, Bob and Mary are married and file their taxes jointly. Bob and Mary each earn $50,000 per year, totaling $100,000 for the household. They are both 52 years of age and qualify for “catch up” contributions, which mean they can invest the highest amount in each type of account.
Bob and Mary both contribute the maximum amount in their 401(k) and traditional IRA accounts, which totals $40,000 in their 401(k) accounts and $10,000 in their IRA accounts. When tax time comes, instead of paying taxes on $100,000, they only pay taxes on $50,000, the amount after their retirement contributions.
The tax bracket for $100,000 per year, married filing jointly is $8,440 plus 25% of any amount over $61,300. Therefore, their tax burden, based on this information alone, would be $18,115 ($8,440 + $9,675).
However, the tax bracket for $50,000 per year, married filing jointly is $1,510 plus 15% of any amount over $15,100. Therefore, based on this information alone, their tax burden would be $6,745 ($1,510 + $5,235). That is a difference of $11,370 paid in taxes!
Keep in mind this is a simple example. Other factors, such as deductions and credits available, would also play a factor in determining tax liability. However, it is clear how much money can be saved by redirecting income into retirement accounts.
There are also other types of retirement accounts that provide as much, if not more, tax benefits. Depending on the type of account you choose, the amount that can be contributed is determined. Some accounts allow you to redirect as much as $42,000 in a retirement account!
This information does not even take into account the amount of money you save in taxes when you consider the growth in these accounts. For example, another simplified illustration, if you contribute $15,000 to your retirement account and it grows at a rate on 8%, not considering compounding, you would earn $1,200 on that investment. If this were a stock investment you would pay taxes on the $1,200 growth. However, because it is in a retirement account, you would not pay taxes on it and it would be compounded to grow even more for your future.