Investing Unit 7: Advantages of Retirement Accounts

Personal Finance January 10, 2018 Print Friendly and PDF

 


Advantages of Retirement Accounts

A major advantage of tax-deferred investing is making contributions to a retirement account with pre-tax dollars. In many instances [e.g., 401(k) plans], the government allows taxable income to be reduced by the amount of the contribution to a tax-deferred retirement plan. As a result, you can have the same amount of money in your pocket and invest what you would have paid the government. For instance, if you are in the 22% marginal income tax bracket and you contribute $1,000 to a tax-deferred retirement plan, you would lower your federal income taxes by $220 (0.22 times $1,000). The savings is based on your marginal tax rate, i.e., the rate you pay on the highest dollar of earnings.

There are seven different tax rates in 2018-- 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The higher your marginal tax rate, the more you, as an investor, benefit from pre-tax dollar contributions to retirement savings plans and tax-deferred earnings. Figure 1 shows the 2018 tax rate schedules for your reference in determining marginal tax rates. These figures are adjusted annually for inflation.

Figure 1. 2018 Tax Rate Schedules

Single-Schedule X

Taxable Income Over But Not Over Marginal Tax Rate
$0

   $9,525

 10%
     9,525    38,700  12%
   38,700    82,500  22%
   82,500  157,500  24%
 157,500  200,000  32%
 200,000  500,000  35%
500.000 ---  37%

Head of household-Schedule Z

Taxable Income Over But Not Over Marginal Tax Rate
$0  $13,600  10%
   13,600    51,800  12%
   51,800  82,500  22%
   82,500  157,500  24%
 157,500  200,000  32%
 200,000 500,000  35%
500,000 ---  37%

Married filing jointly or Qualifying widow(er) - Schedule Y-1

Taxable Income Over But Not Over Marginal Tax Rate
$0  $19,050  10%
   19,050    77,400  12%
   77,400  165,000  22%
 165,000  315,000  24%
 315,000  400,000  32%
 400,000 600,000  35%
600,000 ---  37%

Married filing separately - Schedule Y-2

Taxable Income Over But Not Over Marginal Tax Rate
$0    $9,525  10%
   9,525    38,700  15%
  38,700    82,500  22%
  82,500  157,500  24%
 157,500  200,000  32%
 200,000 300,000  35%
300,000 ---  37%

 

A second advantage of tax-deferred investing is that earnings grow faster because they aren't taxed until withdrawn. Instead of paying tax on the interest earned, it continues to compound until the investment is sold. Over time, the gap between the value of a taxable and a tax-deferred account, earning the same rate of interest, increases sharply.

 

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This work is supported by the USDA National Institute of Food and Agriculture, New Technologies for Ag Extension project.