Introduction to Pre-Tax and Post-Tax Retirements
This article is not designed to discuss what type of retirement vehicle outperforms another. Rather, it is simply designed to discuss the huge advantages of having a post-tax tax-free retirement. Yes, that is correct, I said tax-free. In my day-day-to-day interactions with clients it is common to get requests to do everything possible to lower taxes. Oftentimes this is in the form of SEP-IRA or IRA contributions, which are pre-tax (or tax deductible) savings vehicles. However, what they do not realize is that what may save you today, may cause you much much more later.
I have created two examples to illustrate this. One is a pre-tax contribution and one is post-tax contribution. The presumptions are a one-time initial contribution, a one-time distribution, a modest rate of return of 8% per year, tax base percentage of 25% and a 27 year time period (the rule of 72 was used to figure out the doubling of money rate.)
I have created two examples to illustrate this. One is a pre-tax contribution and one is post-tax contribution. The presumptions are a one-time initial contribution, a one-time distribution, a modest rate of return of 8% per year, tax base percentage of 25% and a 27 year time period (the rule of 72 was used to figure out the doubling of money rate.)
Now, before you go and try to find flaws in the calculation because inflation is not taken into account on the tax savings. Do the calculation first. The tax-savings over 27 years, indexed for a 3% per year inflationary rate comes out to...wait for it...that's right, only $26,957 and some change. Look back at Example A, does taking into account the inflation rate of the tax savings make the tax-deductible contribution scenario in Example A a better than Example B? The answer is still clearly no. Also, the idea that taxes will be less in retirement is just that, an idea. The reality is they most likely will go up, but assuming they did not, typically most people are in a higher tax bracket in their retirement years than they were in their early working years. This is due to taxable retirement income without the deductions of kids, home mortgage interest and other tax reducing deductions. However, Example B is so powerful, that even if you lowered the total tax rate on Example A, you could not out perform the net distribution of Example B.
It is important to note that not all vehicles work for everyone. That is why you should always work with an experienced and trust-worthy planner before making any major financial decisions.
It is important to note that not all vehicles work for everyone. That is why you should always work with an experienced and trust-worthy planner before making any major financial decisions.
Things to know
401(k) - In the United States, a 401(k) plan is the tax-qualified, defined-contribution pension account defined in subsection 401(k) of the Internal Revenue Code.[1]Under the plan, retirement savings contributions are provided (and sometimes proportionately matched) by an employer, deducted from the employee's paycheck before taxation (therefore tax-deferred until withdrawn after retirement or as otherwise permitted by applicable law), and limited to a maximum pre-tax annual contribution of $17,500 (as of 2014).[2][3]
Other employer-provided defined-contribution plans include 403(b) plans, for nonprofit institutions, and 457(b) plans for governmental employers. These plans are all established under section 401(a) of the Internal Revenue Code. 401(a) plans may provide total annual addition of $52,000 (as of 2014) per plan participant, including both employee and employer contributions.*
403(b) - A 403(b) plan is a U.S. tax-advantaged retirement savings plan available for public education organizations, some non-profit employers (only Internal Revenue Code 501(c)(3) organizations), cooperative hospital service organizations, and self-employed ministers in the United States. It has tax treatment similar to a 401(k) plan, especially after the Economic Growth and Tax Relief Reconciliation Act of 2001.
Employee salary deferrals into a 403(b) plan are made before income tax is paid and allowed to grow tax-deferred until the money is taxed as income when withdrawn from the plan.
403(b) plans are also referred to as a tax-sheltered annuity although since 1974 they no longer are restricted to an annuity form and participants can also invest in mutual funds.[1] **
IRA - An Individual Retirement Account[1] is a form of "individual retirement plan",[2] provided by many financial institutions, that provides tax advantages for retirement savings in the United States. An individual retirement account is a type of "individual retirement arrangement"[3] as described in IRS Publication 590, Individual Retirement Arrangements (IRAs).[4] The term IRA, used to describe both individual retirement accounts and the broader category of individual retirement arrangements, encompasses an individual retirement account; a trust or custodial account set up for the exclusive benefit of taxpayers or their beneficiaries; and an individual retirement annuity,[5] by which the taxpayers purchase an annuity contract or an endowment contract from a life insurance company.[6] ***
SEP-IRA - A Simplified Employee Pension Individual Retirement Arrangement (SEP IRA) is a variation of the Individual Retirement Account used in the United States. SEP IRAs are adopted by business owners to provide retirement benefits for the business owners and their employees. There are no significant administration costs for self-employed person with no employees. If the self-employed person does have employees, all employees must receive the same benefits under a SEP plan. Since SEP accounts are treated as IRAs, funds can be invested the same way as any other IRA. ****
Roth-IRA - A Roth IRA (Individual Retirement Arrangement) is a certain type of retirement plan under US law that is generally not taxed, provided certain conditions are met. The tax law of the United States allows a tax reduction on a limited amount of saving for retirement. The Roth IRA's principal difference from most other tax advantaged retirement plans is that, rather than granting a tax break for money placed into the plan, the tax break is granted on the money withdrawn from the plan during retirement.
A Roth IRA can be an individual retirement account containing investments in securities, usually common stocks and bonds, often through mutual funds(although other investments, including derivatives, notes, certificates of deposit, and real estate are possible). A Roth IRA can also be an individual retirementannuity, which is an annuity contract or an endowment contract purchased from a life insurance company. As with all IRAs, the Internal Revenue Servicemandates specific eligibility and filing status requirements. A Roth IRA's main advantages are its tax structure and the additional flexibility that this tax structure provides. Also, there are fewer restrictions on the investments that can be made in the plan than many other tax advantaged plans, and this adds somewhat to the popularity, though the investment options available depend on the trustee (or the place where the plan is established).
The total contributions allowed per year to all IRAs is the lesser of one's taxable compensation (which is not the same as adjusted gross income) and the limit amounts as seen below (this total may be split up between any number of traditional and Roth IRAs. In the case of a married couple, each spouse may contribute the amount listed):
| Age 49 and Below | Age 50 and Above | |
|---|---|---|
| 1998–2001 | $2,000 | $2,000 |
| 2002–2004 | $3,000 | $3,500 |
| 2005 | $4,000 | $4,500 |
| 2006–2007 | $4,000 | $5,000 |
| 2008–2012* | $5,000 | $6,000 |
| 2013–2014 | $5,500 | $6,500 |
For example, if one is single, aged 49 or under, and earns $10,000, one can contribute a maximum of $5,000 in 2008. *****
Annuity - A life annuity is a financial contract in the form of an insurance product according to which a seller (issuer) — typically a financial institution such as a life insurance company — makes a series of future payments to a buyer (annuitant) in exchange for the immediate payment of a lump sum (single-payment annuity) or a series of regular payments (regular-payment annuity), prior to the onset of the annuity.
The payment stream from the issuer to the annuitant has an unknown duration based principally upon the date of death of the annuitant. At this point the contract will terminate and the remainder of the fund accumulated is forfeited unless there are other annuitants or beneficiaries in the contract. Thus a life annuity is a form of longevity insurance, where the uncertainty of an individual's lifespan is transferred from the individual to the insurer, which reduces its own uncertainty by pooling many clients. Annuities can be purchased to provide an income during retirement, or originate from a structured settlement of a personal injury lawsuit. ******
Cash Value Life Insurance - Permanent life insurance is a term sometimes used for life insurance, such as whole life or endowment, where the sum assured is due to be paid out at the end of the policy (assuming the policy is kept current) and the policy accrues a cash value.
This is contrasted with Term life insurance where insurance is purchased for a specified period (such as 5, 10, or 20 years) and a benefit is only paid out if the insured dies during this period.
The earliest form of permanent life insurance was offered in the 18th century as a fixed premium fixed return product known as whole life insurance. There were untold variations on this theme over the years. One example, which became popular in the United States in the late 20th century, was "universal life insurance". This allowed the policyholder considerable flexibility as to the amounts and timing of premiums. Some versions also allowed the policyholder to partially encash the policy (as opposed to taking a loan on the security of the policy) without the interest associated with the loan provisions in whole life policies. "Variable life insurance" or "linked life assurance" is similar, but the benefits are more directly linked to investment performance, thus shifting some risk to the policyholder.
As permanent life insurance program is designed to pay out a benefit in all cases, the premiums are much higher than for term assurance, which can be regarded as pure death benefit with no investment element. Thus many people select term insurance for its low cost, and they may invest the difference in separate investments. Another commonly used tactic is to utilize the slow, steady, growth within the cash value of permanent life insurance as a conservative savings strategy to hedge against the risk of the market. *******
* http://en.wikipedia.org/wiki/401(k)
** http://en.wikipedia.org/wiki/403(b)
*** http://en.wikipedia.org/wiki/Individual_retirement_account
**** http://en.wikipedia.org/wiki/SEP-IRA
***** http://en.wikipedia.org/wiki/Roth_IRA
****** http://en.wikipedia.org/wiki/Life_annuity
******* http://en.wikipedia.org/wiki/Permanent_life_insurance
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