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What Type of Retirement Plan Should My Business Implement? (Part 8)

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The Benefits of Saving in a Retirement Plan or IRA

Why should someone save in an IRA or a retirement plan, instead of a regular savings account? Individual Retirement Accounts (IRAs) and retirement plans provide tax advantages that a regular savings account does not.

There are two types of tax advantages:

Pre-tax: Making a traditional IRA contribution or pre-tax 401(k) deferral, you do not pay federal income tax on money that you save today, but will be taxed when you make withdrawals.

After-tax: Making a Roth IRA contribution or a Roth 401(k) deferral, you pay taxes today, but are not taxed on the investment returns, as long as certain requirements are met.

Which types of savings results in more retirement dollars? There isn’t a black-and-white answer to this, as there are many factors that an individual should consider. But with both types of retirement savings, there are tax advantages on the investment returns that are not available in a non-retirement account. This is demonstrated in the illustration below (assuming you have a consistent tax rate of 28%):

Age when Contributions BeginBi-Weekly ContributionAssumed Earnings RateAfter-Tax Value at Age 70
Savings Account$72*6%**$153,225
Roth After-Tax Savings$72*6%$223,483
Pre-Tax Savings$1006%$223,483

*Assumes that you have only $72 left to invest because you will pay $28 in taxes today on $100 contribution.
**Your realized rate of return will be 4.32% because the 6% return will be subject to 28% tax rate.
†Amount represents value of all contributions and earnings over the past 35 years, after taxation at 28%.

It’s interesting to note that Roth and Pre-Tax values at age 70 are identical. This is because the example assumes that the tax rate is the same when the Roth contributions are made, and when the pre-tax account is taxed. Oftentimes Roth contributions are recommended when you are in a lower tax bracket than you expect to be in when you retire. Or sometimes, Roth contributions are recommended for long-term estate planning when the interest can grow tax-free for generations to come.

As illustrated above, saving in a retirement account provides advantages because of the way investment returns are taxed differently than a regular savings account. Because of the tax advantages on the investment returns, it makes saving early even more valuable.

PRACTICAL TIP: Saving early is extremely beneficial. This is because the investment returns you earn each year are added to your contributions, so your balance doesn’t merely grow, it grows at an increasing rate. Said in a different way, you start earning interest on your interest!

Best way to understand the compounding effect of earning interest on interest is by seeing the impact of starting to save at different ages:

Age when Contributions BeginBi-Weekly ContributionAssumed Earnings RateAfter-Tax Value at Age 70
25$1006%$600,835
35$1006%$310,394
45$1006%$150,885

Saving at the same contribution level but starting 10 years earlier or 20 years earlier has an enormous impact on the value of your retirement account over the long-term. Making small sacrifices today pays huge dividends down the road.

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