Thursday, May 27, 2010

Tax Advantaged Accounts

Another financial myth out there is tax advantaged accounts. There are countless tax strategies to go with the countless tax laws. I say countless because by the time you finish counting them the number has changed. Some of the most common tax strategies involve some sort of tax deferred investment account, the most common being 401k.
            The benefit of a 401k account is that you can invest pre-tax dollars and allow them to grow tax deferred until you withdrawal them. This is nice, but only helpful if you will be paying less taxes when you withdrawal money than you would have to pay now. If the amount of taxes doesn’t change then it does not matter if you invest pre or post tax money. This is demonstrated by the chart below. In this example we have a 35% tax rate. We start with $10,000 pre-tax and $6,500 post-tax and invest it at 7% for 10 years. At the end of 10 years the post-tax money has only grown to $12,786, while the pre-tax money has grown to $19,672, but we still have to pay 35% of that to taxes. After we do that we end up with the same $12,786.


After 10 Years
Tax Rate
 $ 19,672
 $   6,885
 $ 10,000
 $ 12,786
 $   6,500
 $ 12,786

            If your employer does not offer a 401k, you are probably eligible for an IRA (Individual Retirement Account). As far as pre- and post-tax income, an IRA works the same way as a 401k. If you are eligible for an IRA you are most likely eligible for a Roth IRA which allows you to invest post-tax income.
            So the question that each individual has to ask themselves is when will they be paying a higher tax rate; now or in the future? There are two variables when it comes to the amount of taxes you pay; the first is tax bracket, the second is tax law. Your tax bracket changes as your income changes. The more income you make the higher tax bracket you will be in. Higher tax brackets generally pay a higher tax rate.
            Many people believe that when they retire they will be in a lower tax bracket than what they are in now. That isn’t necessarily true. Just think about what retirement is. Retirement is like turning everyday into a Saturday. What do we do on Saturdays? Spend money. During retirement your free time will be plentiful, and you will search for things to do during this time. As you fill your time with multiple entertainment activities it is likely that your expenses will go up as well as your retirement income needs. If your income needs go up, to fill those needs you will withdrawal more income and may unwillingly move into a higher tax bracket. Granted, all of this is relative and dependent on your income just before you retire.
            Some may argue that you won’t have expenses like house payments, and car payments because you’ve paid those off. The flaw in that logic is that cars wear out and have to be maintained or replaced. Houses start to require more and more maintenance; paint, siding, roofing, pluming, etc. Not only that but you will still have to pay car insurance, home owners insurance, and property taxes. So the only thing you can do is estimate your retirement income needs to the best of your ability. Giving the benefit of a doubt, and saying that the debts you pay off do somehow compensate for the increase in entertainment spending, you can estimate your needed retirement income the same way that needs based planning does it; adjust your current income needs for inflation. As we have already discussed, this is not an accurate or reliable method, but it is about all we have right now. Still, I would not depend on it.
            When it comes down to it, the decision must be an individual decision considering your current income, outlook for future employment and income, your own personal habits, and what you think or want your retirement to be like. Luckily for many young professionals while they are in college and starting their careers they will most likely be in one of the lowest tax brackets. This is virtually the only time anyone can accurately know they will likely be in a higher or similar tax bracket when they retire. I would recommend that anyone in the lowest tax bracket use as much post-tax money as possible for their investments. Coincidently, because of the law of compounding, this is also the most important time for an individual to save for retirement.
            Something else that should be considered is tax law. Will taxes go up or down. I will write more on this subject in the future, but until then a nice little blog about past and future taxes go to


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