This is the fourth in a series of six articles detailing information every person who wants to take control of their financial future should know.
An ordinary person can save hundreds of thousands of dollars by taking advantage of tax rules. Money invested in a government authorized retirement account such as a Roth IRA grows tax-free over the investment years. Let’s go back to the $5,500 a year example mentioned in previous articles. That money is allowed to grow tax-free, at 7%, over all the years of investment. At the end of 40 years, you have paid no taxes on those earnings, and you have accumulated $1.2 million.
If you had invested this same amount in stocks and bonds in an ordinary brokerage account, you could be subjected to taxes of at least 15% each year. That means that at the end of 37 years of investing you would have accumulated only $900,000. $1.2 million in a Roth IRA or $900,000 in an ordinary brokerage account is a difference of over $300,000.
The Cherry on the Top
The carnage does not end there. Investments in a Roth IRA not only grow tax-free over the years, but they are also not subject to taxes upon withdrawals after age 59 ½. If you earn $80,000 a year from your Roth IRA investment, you can withdraw this income tax-free, year after year. However, if you had to go out and earn this same amount, $80,000, your “earned income” is subject to Social Security taxes, Medicare taxes, Federal Income taxes, and possible State Income taxes. In some cases, you end up with take home pay of less than $67,000. You have to go out and work every day and pay the government over $13,000 for the privilege.
How this works
These “tax preferences” were enacted by Congress to encourage people to save for their retirements. Many plans allow earnings to grow tax-free over the years and some plans allow all earnings to be withdrawn tax-free at retirement age.
This is how it works. Jane opens up a Roth IRA when she starts working at age 23. She contributes her maximum allowed amount of $5,500 with after-tax dollars. She is allowed to invest in stocks, bonds, certificates of deposit (to name a few examples) in her Roth IRA account. Her Roth IRA basically acts as a “garage” to shelter her portfolio from taxes. At age 59½ , Jane does a “happy dance,” withdraws her income tax-free every year and never looks back.
This same preferential treatment is accorded to people who invest in a designated college savings program (a 529 plan). All investments are allowed to grow tax-free and are not taxed when the money is withdrawn at college age for education purposes.
There are several other “retirement plans” sanctioned by Congress for self-employed people and corporate employees. One of the more interesting retirement plans is a 401K available through employers. If an employer sets up a 401K for their employees, there is a monetary matching provision. For example, an employee might contribute 5% of their income in one year—say $2,500. The employer would then match this amount by $2,500 and the total of $5,000 is invested and is allowed to grow year-after-year tax-free.
This is an automatic 100% return on the $2,500 employee investment year after year. Do note that, depending on the plan, the gains can be subject to taxes upon withdrawal. Sadly, some employees do not take advantage of this free money giveaway.
Check before you commit
Some retirement accounts are funded with before-tax dollars, some with after-tax dollars, some earnings are taxed when withdrawn and some are not. Often, there are large penalties for withdrawing money from your designated retirement accounts before age 59 ½. It literally pays to do your research and/or consult a tax preparer.
Your Next Graduation Day
The wonderful outcome of any consistent and successful investment program is the day you figuratively “graduate” from working. It’s like having all the fun of being a teenager, but with a lot more money, and no parental supervision.
(Illustration by David Darchicourt)