Home / Finances / Honest Talk about Actual Tax Deferral Benefits

Honest Talk about Actual Tax Deferral Benefits

Picture of mature couple talking to financial planner at home.A short, technical blog post this week: I want to talk very precisely about the actual tax deferral benefits you get when you use something like an IRA, 401(k) account or other similar arrangement to defer taxes.

In other words, how much do you really save when you use one of these retirement planning options? The truth is probably different that most people believe.

How People Commonly Account for Tax Deferred Benefits

Often people take a simple approach to estimating the tax deferral benefits of something like an IRA or 401(k) plan.

If someone’s top (or marginal tax) rate equals 30%, the taxpayer assumes that roughly the benefit equals 30%. A $10,000 contribution to a 401(k) or a couple of IRAs, the thinking goes, saves around $3,000.

What’s Wrong with the Traditional Way of Looking at Tax Deferral Benefits

What’s wrong about this approach are two big things and then one small more subtle thing.

The first big thing: When the taxpayer withdraws the money later on, he or she will pay income taxes then. So if you or I get a $3,000 tax savings when the money goes into the account, we need to remember that if we’re subject to income taxes when we later draw the money, we have to give back part of the savings received earlier.

A second big thing: Even if the taxpayer does have to pay back some portion of the tax deferral benefit, he or she gets to invest that money for the years before withdrawal. Yes, the taxpayer will have to pay income taxes on a share of the profits, but the leftover, after-tax chunk, he or she will get.

A third small subtle thing occurs with a tax-deferred account too—and it’s worth mentioning: Investment income that might be treated preferentially (such as qualified dividends, long-term capital gain and unrealized appreciation when the taxpayer dies) gets converted to ordinary income when you use a tax deferred account.

Getting More Precise About Tax Deferral Benefits

I’ve got an Excel spreadsheet you can use to construct scenarios useful for quantifying the benefits and costs of your tax-deferred investing.

Available here (ValueTaxDeferredInvesting), the spreadsheet collects less than a dozen inputs about your savings and investments and then estimates future tax-deferred and not-tax-deferred retirement balances and also future retirement income amounts when you’re using a tax-deferred approach and when you’re not using a tax-deferred approach.

Note: In the spreadsheet, you enter values into the cells highlighted in light green (green signals “go”) and then you shouldn’t enter values into the cells highlighted in yellow because those cells hold the formulas that calculate the values (yellow signals “caution.”) You can edit these formulas, of course. Just be careful.

Some Generalizations about Tax Deferral Benefits

Let me quickly share a handful of easy to remember generalizations about the tax deferral benefits you get from something like an IRA or 401(k).

First generalization: The tax deferral benefit is significant but often less than you might expect. You’re going to bump your retirement income amount by ten or twenty percent in common scenarios. And that’s great. But one might be tempted to overestimate the benefits.

Example: A $50,000 draw from a taxable account maybe gets bumped up to $55,000 or best case $60,000 if you use an IRA or 401(k).

A second generalization: The real financial benefit of a tax deferred accounts comes from the drop in your marginal tax rate once you retire. If you play with the spreadsheet, for example, and set the ordinary tax rate while you’re contributing money to the same value as when you’re withdrawing money, you can eliminate the tax savings.

And a third generalization: The loss of preferential tax rates due to long-term capital gains, preferred dividends, and untaxed unrealized appreciation can completely wipe out the benefit of the whole “borrowing money tax free from the IRS” benefit.

A Final Comment

Tax-deferred retirement accounts represent a great investment approach. We absolutely want to use them as much as possible. Especially if we haven’t really saved enough for retirement and so face a low retirement tax rate. But these options aren’t such a good deal that we can be thoughtless or careless about the costs of using this approach.

Furthermore, do be careful you don’t overestimate the benefit of the deferral. My modeling suggests it’s easy to make that mistake…

Related Relevant Posts You Might Like

$10,000,000 IRAs and 401(k) Accounts: Really Possible?

Absurdly Good Retirements: What Small Businesses Can Learn from Public Employee Retirement Plans

Why You Don’t Need to Worry about Your Taxes in Retirement

 

 

The post Honest Talk about Actual Tax Deferral Benefits appeared first on Evergreen Small Business.

Click Here For Original Source Of The Article

Check Also

Financially Independent Retired Early: Flaws with Philosophy?

Financially Independent Retired Early: Flaws with Philosophy?

Okay, an important first stipulation. I totally understand the allure of the financially independent retired early strategy. Further, I totally agree with the idea that if you can truly arrange[...]

The post Financially Independent Retired Early: Flaws with Philosophy? appeared first on Evergreen Small Business.

Leave a Reply

Your email address will not be published. Required fields are marked *

css.php