Investing Unit 7: Advantages of Retirement Accounts

Personal Finance January 05, 2017 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 25% marginal income tax bracket and you contribute $1,000 to a tax-deferred retirement plan, you would lower your federal income taxes by $250 (0.25 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 2017-- 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. The higher your marginal tax rate, the more you, as an investor, benefit from pretax dollar contributions and tax-deferred earnings. Figure 1 shows the 2017 tax rate schedules for your reference in determining marginal tax rates. These figures are adjusted annually for inflation.

Figure 1. 2017 Tax Rate Schedules

Single-Schedule X

Taxable Income Over But Not Over Marginal Tax Rate
$0

   $9,325

 10%
     9,325    37,950  15%
   37,950    91,900  25%
   91,900  191,650  28%
 191,650  416,700  33%
 416,700  418,400  35%
418,400 --- 39.6%

Head of household-Schedule Z

Taxable Income Over But Not Over Marginal Tax Rate
$0  $13,350  10%
   13,350    50,800  15%
   50,800  131,200  25%
 131,200  212,500  28%
 212,500  416,700  33%
 416,700 444,550  35%
444,550 --- 39.6%

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

Taxable Income Over But Not Over Marginal Tax Rate
$0  $18,650  10%
   18,650    75,900  15%
   75,900  153,100  25%
 153,100  233,350  28%
 233,350  416,700  33%
 416,700 470,700  35%
470,700 --- 39.6%

Married filing separately - Schedule Y-2

Taxable Income Over But Not Over Marginal Tax Rate
$0    $9,325  10%
   9,325    37,950  15%
  37,950    76,550  25%
  76,550  116,675  28%
 116,675  208,350  33%
 208,350 235,350  35%
235,350 --- 39.6%

 

A second advantage of tax-deferred investing is that earnings grow faster because they aren't taxed until withdrawn.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.