You Can Save Faster with Tax-deductible Qualified Plans in 3 Ways
by Shane Flait (2010)

If you’re trying to beef-up your retirement savings in just a few years, use tax-deductible qualified plans (including IRAs) to do so. In this article I outline why they can give you the most benefit for your contribution efforts.

The company you work for has qualified plans you can contribute to – like a 401(k). And you always can make contributions to your own IRA.  Both of these qualified plans have a tax-deductible contribution version and a non tax-deductible contribution version – often called a Roth plan.  Choose the tax-deductible contribution version. Here’s why.

Making tax-deductible contributions to both your IRA and 401(k) at work can benefit you in at least three ways:

1.      The tax-deductable contributions help you put more of your working income into savings,

2.      Your employer may match some of your 401(k) contributions

3.      You can profit when you withdraw your money at a lower tax bracket than you contributed – even without a growth in earnings.

The tax-deductable contribution helps you put more of your working income into savings

With normal savings or even nontax-deductible retirement plans you can only contribute your working income after it’s been taxed. But by choosing a tax-deducible 401(k) and IRA, the deduction you get for contributing a $1,000 not only puts $1,000 into your savings but reduces your income tax according to your tax bracket.

At the same time, you save $250 (= 25% x $1,000) in taxes if your contribution would have been taxed at 25% because of the tax-deduction of your contribution. That means that if you hadn’t made that tax-deductible contribution, you’d have had to pay $250 more in taxes – and therefore had only $750 left to save. If you’re in the 33% bracket the corresponding figure would be $333 (= 33% x $1,000) with only $667 left to save.

Also, if you’re having trouble finding working income to save with, your can pick up a part-time job. Your tax-deductible contribution (perhaps for you IRA) will shelter the extra taxation that part-time income is taxed at.

Your employer may match some of your 401(k) contributions

Employers sometime match some amount of your contributions to your 401(k). That means you’ve immediately made a 100% profit on those matched contributions. It’s crazy not to find some income to contribute – at least – to maximize these company-matched funds for your account.

You can profit when you withdraw your money at a lower tax bracket than you contributed 

One disbenefit of using tax-deductible plans to save is that your withdrawals are taxed at ordinary income tax rates. But this can turn out to be a bonus if you can arrange to have your withdrawals taxed at a lower tax rate than when you contributed. And that’s not hard when you retire – or stop making a lot of income. Here’s how it works.

If you make a $1,000 contribution under your working income that lowers your taxable income within the 28% tax bracket, you’ve reduced your taxes by $280. So that $1,000 cost you only $720 of your after tax take-home pay – as mentioned above. But then, if you retired a year later, and withdrew that money so that it added income to you at only the 10% tax bracket, then you’d owe $100 for taking out your $1,000. So you’d have $900 of after tax money – if your investment neither grew nor lessened!

So, by using the tax-deductible plan for saving $1,000, you’ve converted what would have been $720 in your pocket to $900 in your pocket just one year later! Whether you wait a year or 5 years until you make a withdrawal, you’ll still get the ‘tax profit’ benefit – aside from your investment growth.

 

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