Usually, investing the maximum amount of your earned income allowed into a retirement account, such as an IRA (Individual Retirement Account), 401(k) or any other tax-deferred plan is an excellent move. This should be money, however, that won’t be needed in the near future and can be invested for a long time. This is because most of these programs penalize you for money you withdraw before age 59½.
Keep in mind that an IRA can take the form of many different types of investment vehicles, such as a savings account, CDs and, of course, mutual funds. There is no difference between investing in a regular mutual fund account or in a mutual fund as an IRA, except how the government views it for tax purposes.
Just so we’re clear, tax-deferred means that, you don’t have to pay tax on any of the capital gains and/or dividends you earn during the years your investment is growing. The taxes are paid when you begin withdrawing the money.
As an example, let’s say you were going to invest $2,000 per year for 40 years and you were able to average 10 percent annual interest during that time. (I used $2,000 in these examples, but you can contribute more if you choose, subject to IRA contribution limits.) If you were in the 28 percent tax bracket, your investment in a taxable account (one in which you had to pay taxes annually on your gains) would total approximately $450,000.
That same exact investment in a tax-deferred account would total approximately 973,000 — more than double! Now let’s say you could do a little better on your investment, this time earning 12 percent. You would still invest $2,000 over 40 years. Now your taxable account would total almost $667,000 and your tax-deferred account would be over $1,700,000. That’s an extra million dollars!
Another option is the Roth IRA, named after Senator William Roth who invented it. It’s the retirement vehicle of choice for many people who don’t have employee-sponsored plans. In a Roth IRA, you invest with after-tax dollars, as opposed to a traditional IRA, in which you usually invest with pre-tax contributions (meaning you get to deduct them from your income that year).
Since your contributions in a Roth IRA are made with after-tax dollars, (meaning you did not get a tax-deduction for them) the government allows your money to grow tax-free! (Assuming all the guidelines have been met) This obviously means a lot more money for you.
Be sure to check with your financial advisor and your accountant when deciding which type of retirement account is right for you. Once you find out which program is best for you, let the government begin helping you to build your nest egg through reduced taxes.
Tags: investment advice, financial advisor, retirement planning, financial advice, personal finance, compound interest, tax-deferred growth