Make a Tax-based Profit on Your IRA Contribution If You’re Retiring Soon
by Shane Flait (2010)

 

Government-regulated retirement plans, like IRAs and 401(k)s, offer you a tax-advantage. Your contributions are tax-deductible whose earnings then grow tax-deferred. Withdrawals are taxed as income. With no investment gain – or loss – you can make a tax-based profit by contributing at high income tax rates, and then withdraw at a low income tax rates. This article shows you why.

 

Soon-to-be retirees should consider making contributions to their IRA or 401(k) just to reap a tax profit. This presumes that their contributions are made when they have a high income because they’re still working. And it presumes they’ll withdraw from their plan under a low income retirement situation. The reduction in your tax-bracket alone between the contribution and withdrawal times will make you a profit. Here’s how

 

First, your income – and only that income above your standard deduction and exemption - is taxable income and taxed at successively higher tax rates. These tax rates for successively higher taxable income brackets are 10%, 15%, 25%, 28% and 33%. 

 

Now, all deductions you make from your taxable income or additions to your taxable income subtract or add at your highest tax bracket.  So, if you made a tax deductible contribution of $1,000 to your 401(k) when your income was high enough to ‘subtract’ that $1,000 within the 28% tax rate bracket, then you’d have $1,000 sitting in your retirement plan and have saved $280 of income taxes (28% of $1,000) by making that contribution.

 

Had you not contributed, you’d only have $720 (72% of $1,000) in you pocket. You could say that using the retirement plan your $1,000 contribution only cost you $720.

 

Suppose a year later you retire but that $1,000 investment in your 401(k) remained flat so there were no earnings or losses. If your retirement income from your pension, Social Security, and other earnings is sufficiently low, your withdrawal of that $1,000 – which is added to your income – might only be taxed at the 15% tax rate. That means after paying taxes (i.e. $150 on the $1,000), you’ll have $850 (85% of $1,000) in your pocket.

 

So for having made that $1,000 contribution to your government-regulated savings plan and then withdrawn it later, you’ve converted what would have been $720 in your pocket to $850 in your pocket. That’s a return of investment of 18% in one year; and it’s all tax-based profit! Clearly if you can spread your contributions and withdrawals between larger tax rate changes, you’ll make even more.    

 

That’s why those nearing retirement ought to make contributions to tax-deductible retirement savings plans even though they expect little growth time for their investments. In fact they should invest those contributions in conservative investments just to make sure there’s little or no chance of loss.

 

Shane Flait is a writer and educator. See more at www.EasyRetirementKnowHow.com