Not everybody contributes to pre-tax accounts like a 401(k) or traditional IRA. But that omission might be one of the biggest delays you could ever add to your retirement. Here are several reasons why deferring income tax is a great deal:
It lowers your adjusted gross income. When you contribute money to a 401(k) or IRA, it lowers your taxable income. Reducing your adjusted gross income decreases the amount of income you need to pay tax on that year, and may even allow you to claim additional tax breaks that you would have been unable to qualify for with a higher income.
Withdraw money when your tax rate is much lower. Many people have a lower income in retirement than they did while working, which also puts them in a lower tax bracket. For example, if someone is in the 25 percent tax bracket while working, but drops into the 15 percent tax bracket in retirement, they can pay significantly less tax on the money if they defer paying tax on it until retirement.
There are no capital gains and dividend taxes while the assets are accumulating. Don't underestimate the yearly taxes you pay on your investment gains. Even with preferential treatment on long-term capital gains and dividends, you'll save a lot more on your tax bill over your career when your investments are protected from Uncle Sam in a retirement account.
Possibly avoid state taxes on your contributions. Some people relocate to Florida or several other states with no state income tax. If you move to a state without an income tax in retirement before you withdraw money from your pre-tax accounts, you could save quite a bit on your tax bill.
You can control when to take the tax hit. While you cannot predict what tax rates will be in the future, you can wait until a year you are in a low tax bracket to recognize the income you've put into pre-tax accounts. You can even do this before retirement without incurring the early withdrawal penalty by converting money in a 401(k) to a Roth by doing a Roth conversion. When you do a Roth conversion you will need to pay income tax on the amount converted. However, you can pick a year when your earnings are particularly low in order to pay a low tax rate.
Investment gains taxed as ordinary income are no longer handicapped. Some investments, like REITs, for example, generate income taxed at the ordinary income tax rate. For many people, that severely reduces the after-tax return compared to the stock market, where dividends are taxed at a lower rate. When you have assets in a pre-tax account where all withdrawals will be taxed at ordinary income tax rates, you can freely choose the asset that's best for your investment plan without worrying about how taxes will affect the risk/return profile.
Some states have better protections on assets in pre-tax accounts. Your assets in an IRA are much better protected against bankruptcies and lawsuits than money in a taxable account. The protection is even stronger in an employer-sponsored 401(k). Keep this in mind if you have debt and plan to rollover a 401(k) into an IRA.
There are many advantages of deferring taxes on your income by investing in a pre-tax account like a 401(k) or IRA. In many cases, these tax perks can allow you to save more and retire sooner than you could by using a regular investment account.
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