Retirement Planning Tutorial
Taxes and Your Retirement
The reason that retirement accounts are so beneficial is that the government is providing you with the ability, in the case of a Traditional IRA, for tax deferred savings. Tax deferred savings means that the money you deposit into your retirement account is tax-sheltered. Therefore, a majority of what you deposit into the account will go towards earning you return rather than to the government as tax. Don't think the government is not going to get their cut; tax is collected after you retire and begin withdrawing the money.
The advantages of this are enormous. For example, a $1000 deposit would earn $90 at a 9% fixed rate of return, after one year this would amount to $1090. Withdrawing that $1090 and paying income taxes at 30% would leave $763. Meanwhile $700 ($1000 minus 30% taxes) in an after-tax account would need a return of 13% to earn $90 interest or $63 after you are taxed on the interest.
Confused? What this example tells us is that a tax deferred account gives us more money to invest today, which by the laws of compounding means that we should reach our goal much faster.
In some instances combining these deferred investments with after tax investments, such as investing in the stock market can be a good strategy. Remember though, to get the best return you must compare both before-tax and after-tax investment options. If you do decide to choose after-tax investments, then you must be dedicated and disciplined within that investment. By discipline we mean don't use that money for personal purposes, as it's awfully tempting when you have a large sum of money sitting in a brokerage account. In other words don't cash in your "retirement" account equities and buy that stereo you've always wanted. You know as well as we do that those funds probably won't ever be replaced back into your retirement account.