Why Tax Efficient Accounts Matter for Retirement Savings
Tax savings on investments depends on the type of account chosen. You may select an account featuring pre-tax or post-tax contributions, both which offer tax-free growth during your working years. To pay the least amount of taxes, consider the tax treatment on the account before choosing your path to retirement.
Benefits of Pre-Tax Contributions
Depositing money into a retirement account without currently paying taxes on the funds has several key benefits:
- Lower taxable income. Pre-tax contributions lower taxable income dollar-for-dollar. Most tax-deductible contributions create tax-deferred income, meaning you pay taxes at the time of withdrawal. At that time 100% of the balance will have taxes due.
- Faster growth rates. Taxable and Roth accounts reduce the amount of money immediately available for investing. Over time, this increased investment can lead to significantly higher balances due to compound growth. The following chart shows a hypothetical comparison of the tax savings in relation to the growth in account balances over time.
- Lower Taxation over the long Term. During your peak earning years you are likely in a higher tax bracket than you will be in retirement. According to AARP, the average couple earns approximately $31,742 in retirement. The Census Bureau lists the average household income in 2014 at $73,298 for working families. Based on the 2017 tax schedules there is a 10% tax difference between earning $31,742 in taxable income and $73,298.
Regardless of which account you choose, the IRS will tax the money at some point. You get to decide when. For Roth accounts you lose the upfront tax benefit but gain tax-free growth and withdrawals in retirement, creating tax-free income. Tax deferred accounts such as Traditional IRAs, 401Ks, and most workplace accounts, you gain the advantage of pre-tax contributions, which delays taxation until you withdraw funds.