Tax day has come and gone. I hope you squirreled some money away into your tax-deferred accounts. What’s that? You don’t think deferring taxes will really help your finances? Let’s turn to the numbers and see what tale they tell.
First, here’s a brief rundown of the tax-deferred accounts that may be available to you:
- IRA (Individual Retirement Account) – available to everyone but has some income limits. [retirement account]
- 401(k) – available only through your employer, but many employers offer them in some form. [retirement account]
- 403(b) – this is the equivalent of a 401(k) if you work for a non-profit organization. [retirement account]
- 457(b) – this an account that supplements your 401(k) or 403(b), if you have one, and is very similar to them. Mostly only available if you work for a state or the federal government. A key difference between 457(b)s and the other two is that independent contractors can participate in 457(b)s while they cannot participate in 401(k)s or 403(b)s. [retirement account]
- HSA (Health Savings Account) – available only if it comes paired with a high-deductible health insurance plan. [account for covering health-related expenses]
- 529 – available to everyone. These are offered by individual states to help defray education costs. [account for paying education costs]
That’s quite a list! And it pretty much covers it unless you are self-employed. Self-employed people get their own versions of IRAs and 401(k)s, those special little snowflakes.
You may be thinking, “how is that alphabet soup supposed to help me earn more money?” I’m glad you asked.
This post is going to specifically focus on the benefits of tax-deferred accounts. That means we throw the Roth accounts out the window. A Roth account is another type of tax-advantaged account, but that conversation is for another day.
There are all sorts of reasons to put money into each of the accounts above but, for brevity, I’m not going to talk about which ones are best (short answer: depends on your circumstances). I’m just going to help you see why you should be contributing to them. Any of them.
Here’s the deal:
A dollar in your paycheck is worth more money if you put it in a tax-advantaged account.
Every dollar you get on payday has already had federal and (probably) state income taxes taken out. But if you put money into a tax-advantaged account, you get to defer those taxes.
Let’s look at an example. Our old pal, Kringlebert Fistybuns. For clarity, we’ll assume that he only pays federal tax (take that FICA!). Let’s say Kringlebert earns $5000/month in gross pay, so he earns $60,000/year. But poor Kringlebert doesn’t actually get $5000 every month because Uncle Sam takes his cut. Assuming he’s single, Kringlebert is in the 25% tax bracket. Here comes the math!
At 25% tax, $1 in the paycheck = $1.33 in the tax-deferred account.
Wait a minute. That can’t be right. We said 25% tax, not 33% tax. Oh, dear reader, trust The Dragon when it comes to math. The 25% tax applies to the gross pay. Since 25% is tax, Kringlebert takes home 75% and $1.33(.75)=$1.00. What that means is that he could have 33% more money by stashing that cash in a tax-deferred account like a traditional IRA or 401(k)… 33%!!!
Ever felt like giving yourself a 33% raise? Here’s your chance. Put money in your 401(k) or IRA.
Of course, if you aren’t in the 25% tax bracket the math works out differently. Here’s the breakdown for each bracket:
- In the 10% tax bracket, $1 in the paycheck = $1.11 tax-deferred: an 11% raise.
- In the 15% tax bracket, $1 in the paycheck = $1.18 tax-deferred: an 18% raise.
- In the 25% tax bracket, $1 in the paycheck = $1.33 tax-deferred: a 33% raise.
- In the 28% tax bracket, $1 in the paycheck = $1.39 tax-deferred: a 39% raise.
- In the 33% tax bracket, $1 in the paycheck = $1.49 tax-deferred: a 49% raise.
- In the 35% tax bracket, $1 in the paycheck = $1.54 tax-deferred: a 54% raise.
- In the 39.6% tax bracket, $1 in the paycheck = $1.66 tax-deferred: a 66% raise.
Hot damn! That’s some serious coin for the hoard!
The more money you earn, the more lucrative it is to defer taxes*. Especially if you won’t be earning as much money when you retire.
Of course, you probably can’t put your entire salary into tax-deferred accounts. The average person will be able to shield money from taxes in both a 401(k) or 403(b) and an IRA, for a total of $23,500 in 2015. Going back to our example, let’s see how much extra cash Kringlebert can get.
He makes $60,000/yr. We will assume he takes the standard deduction and one personal exemption, so his total taxable income will be $60,000 – $10,300 = $49,700. That means that if he doesn’t defer any taxes he will pay $8,218.75 in federal income tax.
If, instead, he maxes out his 401(k) and IRA, his taxable income will be $60,000 – $23,500 – $10,300 = $26,200. In this case he would pay $3,468.75. That’s $8,218.75 – $3,468.75 = $4,750 in extra cash.
All right, all right, so it’s not a 33% raise on his whole salary. But getting almost $5k just for saving your money is nothing to sneeze at!
Some of you might be nervous about having access to tax-deferred money if you, like me, plan on retiring before the standard retirement age. Luckily some very smart bloggers have well-written posts on how to get your grubby little paws on your hard-earned cash. See these posts:
Traditional IRA vs Roth IRA – The Final Battle (Mad FIentist)
Never Pay Taxes Again (Go Curry Cracker)
Do you max out your retirement accounts? How much are you saving in taxes? Do you sneeze at $5k? Gesundheit!
*Until you reach the income limits for tax deductions. Or until you make enough that subtracting $23,500 from your salary leaves you in the 39.6% tax bracket (if that’s you, you probably have much better tax-avoidance strategies than the ones in this post :)).