Single Deposit Amount: Enter the amount of money you will start your tax-sheltered investment with. Remember that for retirement accounts, you are limited to around $2,000/year for IRAs and somewhat more for 401 (k) accounts.
Annual Deposit Amount: Enter the dollar amount you will contribute each year to your tax-sheltered account.
Years of Growth: Enter the number of years until you stop investing and withdraw your money. Of course, you will probably take gradual payouts on your account rather than withdraw everything at once. But for the sake of seeing the effect of the tax shelter, just pick a number of years until you will have stopped adding to your investment. For most people, this will be the number of years until retirement.
Rate of Return: Enter the annual "rate of return" on your investment; that is, the percentage at which your investment will grow each year. You can find out about average annual rates of return on potential investments by checking out the investment's website or prospectus.
Marginal Tax Rate: Enter the tax rate of your tax bracket. This is the rate you pay on any additional income you might be getting.
After Tax Return: Do not enter anything in this field. This number will be calculated for you automatically.
Investing, Interest, and Taxes: The Value of Tax-Sheltered Investments
The US federal government grants a very powerful gift to anyone saving for retirement: tax exemption for certain retirement savings accounts. Income taxes can easily take anywhere from a fifth to a third of your income, money you normally can't put toward savings. So, by not having to pay income taxes on money you put in a retirement savings account, you have more money to put in. But that's not all. The interest your retirement savings account gains is not taxable either! Historically, the tax rate owed on interest has been at least as high as the tax rate collected on earnings from work, so this is no small change.
When you keep in mind the fact that interest compounds, the value of the "tax shelter" of retirement funds is even greater. That is, if you don't have to pay taxes on your interest this year, you will have an even bigger basis on which to grow interest next year--and the year after that and the year after that.
For instance, say you are 40 today and hope to retire at age 65. If you invest $10,000 today and invest another $1,000 every year thereafter, your investment will grow to $141,591 in a tax-sheltered account (at a conservative 8% annual rate of return). But if you had invested that money in an account without the tax shelter, you would have only $84,578 (assuming you are in the 35% income tax bracket).
Tax-Exempt Retirement Savings Accounts: IRAs and 401 (k)'s
There are two main tax-sheltered retirement savings accounts: IRA and 401 (k). You've no doubt heard of both. What's the difference between IRA and 401 (k) retirement savings accounts? The essential difference is that employers can make contributions to 401 (k) plans and not to IRAs.
The 401(k) is basically the twenty-first century's answer to the old-fashioned pension. With a 401 (k), you can contribute a maximum of either 15% of your salary or $6,000-10,000 (varies by company). Your employer then matches your contribution at 33.3% or more per dollar. In the words of one financial analyst, not using your employer's 401(k) benefit means you have "bricks for brains." It's free money, so take it. You're not going to get a better investment than free money. You can then withdraw your investment tax-free when you turn age 59 1/2. OK, that may seem like a long time to wait, but with any luck you'd be turning 59 1/2 anyway. You might as well have some money to show for it.
If your employer does not offer a 401(k), or if you are self-employed, you would go with an IRA. There are two types of IRAs: Roth and "traditional." Again, you've heard these words before, but what do they mean?
- Traditional IRA: You can usually contribute up to $2,000/year. The contributions will not be taxed, and neither will the interest. You can withdraw your money when you turn 59 1/2 years of age. When you withdraw the money, the interest part of the money you've withdrawn is taxed. Keep in mind that the interest part of the money will likely be larger than your total contributions if you've been investing for 15 years or more.
- Roth IRA: You can usually contribute up to $2,000/year. The contribution, however, is not tax-deductible. But the interest will accrue without being taxed. The best part is when you withdraw money at age 59 1/2 or later, the withdrawals are not at all taxable. Even if you die and the money gets inherited, your heirs won't have to pay tax on it. You can also keep contributing to this fund for as long as you are working and earning money. For most people, this is by far the best IRA.