Power of 401(k) & IRAs Tax Deferred Plans
There are always questions on whether to invest your retirement savings in an IRA, Roth IRA or 401(k). Many people realize that these vehicles are a good investment tool. Yet, they do not know which to invest in. It also gets confusing if your stock broker questions why you are investing in an IRA or 401(k) plan when taxes may go up in the future (to pay for things like Social Security and the national debt). They may suggest that having your money taxed now (thus avoiding these tax deferred plans) and invested with them is a better option. This section will demonstrate why tax deferred vehicles are usually a good idea even if taxes increase modestly in the future.
You may also be questioning which tax deferred vehicle do you invest in? The key is to understand when and how the money is taxed for each vehicle.
So as you can see, a 401(k) plan and IRA have the same tax consequences. Thus, it does not matter from a tax standpoint which vehicle you invest in.
If taxes are constant in the future, 401(k) and IRA have the same tax consequence as the Roth IRA even though the money in a Roth IRA is taxed immediately while money in 401(k) and IRA are taxed when it is withdrawn. Let me show why this is true. Assume that a person age 35 invests $5,000 in each tax deferred vehicle which all earn 8.5% annually and he takes his money out at age 65. Assume the person is also taxed a flat 30% now and in the future.
As you can see each vehicle while end up with the same amount at age 65 ($40,454) under a constant tax rate. One may wonder how this can be when the tax for the Roth IRA was only $1,500 ($5,000 x .30 tax rate) while the 401(k) and IRA the tax is $17,337 ($57,791 x .30 tax rate). This is because the government will take 30% of the money either at the beginning or at the end. Now, imagine your money as a pie circle. If the money (pie circle) expands outward at similar rates, the government will take its 30% slice whether it is on the smaller pie or larger pie. In the end, 30% of the pie is still gone due to taxes. Thus, in an IRA, Roth IRA or 401(k) plan, your share is the remaining 70%.
However, in a non-tax deferred vehicle, the government not only takes its 30% of the money (pie) but a portion of any investment growth
They key to a 401(k), IRA or Roth IRA is that they are only taxed once, while a non-tax deferred investment is taxed twice, once before it is invested and then again on earnings on the investment. In this example, taxes would have to increase from the flat 30% to 51% (a 70% increase in taxes) before a 401(k) and IRA is not as an effective tax vehicle as a non-tax deferred investment ($57,791 x (1 - .51 tax rate) = $28,318). Note, you can increase your tax effectiveness in a non-tax deferred investment by investing more long term (not selling or trading your investments and thus delay paying capital gains tax). However, you are also going to get taxed at the ordinary tax rates (e.g., 30%) on short-term gains and income from other assets like bonds. So, the 15% annual tax may not be far off (or tax rates may be higher) when blending in bonds into your asset mix.
The key is you will always have to pay a second tax on your investment return. So, unless taxes go up significantly in the future (or capital gain rates decrease significantly), 401(k) and IRA plans still appear to be a good tax deferred vehicle to use. Based on $5,000 invested at 10% annual return (pre-tax) with a 30% tax bracket and a 15% capital gains (investment) tax, the difference in post-tax investment and a pre-tax investment is as follows:
Things to Consider
From the examples above, Roth IRAs, IRAs and 401(k) plans are all effective, but which one is the best. There are a few things that can make one of the plans standout.
Sound confusing? The key is to ask yourself where are you in regards to your future tax rates. If you are at the start of your career than a Roth IRA may be more attractive. If you are at the pinnacle of your career, then and IRA or 401(k) plan may look better (especially if your retirement income will be less than your making now).
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