What Are the Benefits to Contributing to an IRA or 401(k) Type Plans?
by Shane Flait (2010)

 

Taxes undermine our ability to grow our wealth and secure our retirement. To help people save for retirement, the government has authorized tax advantages to those who contribute to regulated retirement savings plans. This article explains the benefits of contributing to them.

 

Government-regulated retirement savings plans include the IRA, 401(k), 503(b) and similar government-qualified plans. Such plans are geared to retirement since the government invariably penalize any early withdrawals (before age 59½) you make from them.

 

Generally the annual contribution you can make to a plan is limited – but that depends on the particular plan. To help you out if you get a late start, your maximum annual contribution is increased– as a ‘catch-up’ measure – if you’re over 50. The ‘catch-up’ amount depends on which plan you’re using.

 

The tax advantage of tax-deductible qualified plans

The only way the government can benefit you is by reducing the effects of taxation on what you earn. So these retirement plans are tax-advantaged to help you save more. Most of these plans are ‘tax-deductible’ plans. The tax advantage is that these deductible qualified plans are:

1.      Annual contributions are tax-deductible

2.      Annual earnings within the plan grow tax-deferred, and

3.      Withdrawals from plan savings are taxed as income.

 

The benefit of tax-deductible contributions is that it helps you contribute more to your plan savings. That’s because you don’t have to pay income tax on that ‘contributed’ income so it all goes into the plan to grow.

 

The benefit of tax-deferred growth of earnings within the plan means that some of the earnings aren’t lost to taxes each year. This allows a higher annual compounding rate which means faster growth of your savings.

 

Taxing withdrawals of your plan’s savings at income tax rates is a mixed benefit. It’s a benefit, if your withdrawals are taxed at a lower tax rate than the tax rate at which you made your contributions, so you don’t end up paying back all the tax you didn’t pay when you contributed. And that’s probably the circumstance of most retirees since their retirement incomes are less than their previous working incomes.

 

But even if your withdrawals are taxed at the same rate as when you made your annual contributions, you’d still gain the benefit of tax-deferred growth over the years your savings were in the plan. And this would put you ahead of the same interest-bearing investment in a normal taxable account.

 

The only way you’ll lose the benefit of your tax deductible contributions, will be if your withdrawals are taxed at a greater tax rate than when you made your contributions. If that’s because your typical retirement income is greater than your working income, then you’re in pretty good shape any way.

 

It also can happen that you’re withdrawing so much from the plan that you’ve forced yourself into a much higher tax bracket than you normally would be in. So, always minimize your withdrawals to keep from going into unnecessarily high tax brackets.

 

 

Tax advantage of nondeductible qualified plans

IRAs and most other qualified plans have a ‘nondeductible’ version generally referred to as ‘Roth’ plan- like a Roth IRA. Their penalties and limits are similar to the deductible plans. The corresponding taxation of these plans are:

1.      Annual contributions are not tax-deductible

2.      Annual earnings within the plan grow tax-free, and

3.      Withdrawals from plan savings are tax free

4.      No required minimum withdrawals after 70½

 

The fact the contributions are not tax deductible means it’s harder to contribute. But the benefit is that what you get into the plan will never be taxed again!  Its earnings grow tax-free and what you withdraw comes out tax free since you contributed with after-tax money.  So it doesn’t matter how high your income is during retirement.

 

Lastly, unlike the deductible plans, you – as the owner of the plan - are never required to make a minimum required distribution after turning 70½. So, if you don’t need the money, it can keep growing tax free for as long as you live.

 

Additional Benefits of qualified plans

There is one major benefit - beyond the tax-advantages mentioned above – that makes contributing to qualified plans a good idea. That’s when your qualified plan – under your employer – matches your contributions.

 

Yes, some companies actually match your contribution to your qualified plan (perhaps a 401(k) plan) dollar for dollar up to some percent of your income – perhaps 5%. You may contribute more, but only that 5% will be matched. Not making at least the 5% contribution is crazy since you miss out on getting an immediate 100% return on your investment. Always contribute at least the matching amount percent.

 

Everyone should contribute to IRAs or other qualified plans

 

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