The Tax-Saving Power of Investing Within Retirement Accounts

Investing wisely is a key part of building and preserving wealth, but the vehicles through which you invest can have as big an impact on your outcomes as the investments that drive them. People often overlook retirement accounts as vehicles to make alternative investments where the outcomes can not only be bigger than investments in stocks and bonds, but the tax savings can be outsized as well. This blog will explore these benefits and include a case study to illustrate the potential tax savings.

Understanding the Tax Benefits

When you invest using after-tax cash, you're subject to taxes on capital gains and dividends. Short-term capital gains (from assets held for one year or less) are taxed as ordinary income, while long-term capital gains have lower tax rates. However, both can significantly eat into your profits. In contrast, retirement accounts like IRAs and 401(k)s offer tax-deferred growth, meaning you don't pay taxes on dividends, interest, or capital gains until you withdraw the money in retirement. Roth IRAs and Roth 401(k)s go even further by providing tax-free growth, as contributions are made with after-tax dollars, and qualified withdrawals are tax-free.

Traditional Retirement Accounts

With traditional IRAs and 401(k)s, your contributions may be tax-deductible, reducing your taxable income for the year you contribute. This immediate tax break, combined with the tax-deferred growth of your investments, can lead to substantial tax savings over time. However, you will pay taxes on the withdrawals at your ordinary income tax rate during retirement.

Your investments though will not be taxed, and every investment will grow tax-free inside the account forever. The only times you pay taxes are on withdrawals.

Roth Retirement Accounts

Roth IRAs and Roth 401(k)s do not offer an immediate tax deduction for contributions, but they provide a significant advantage: since withdrawals in retirement are tax-free, all the growth your investments have accumulated over the years escapes taxation entirely. This can be especially beneficial if you expect to be in a higher tax bracket in retirement or if tax rates rise.

Having a combination of traditional and Roth contributions is important; one for the immediate tax savings, and the other for long-term tax savings. One great strategy investors use is to carry out Roth conversions in years where they might be between jobs or have a low-income year, for whatever reason, because then their tax basis could be lower on the conversion.

Case Study: Investing with Cash vs. a Retirement Account

To illustrate the potential tax savings of investing within a retirement account versus using cash, consider the following hypothetical scenario. We will be quite conservative in our annual returns, and the outcome will still be significantly different between cash and a retirement account.

Investing with Cash

When investing with cash, the $6,000 annual investment grows at an average rate of 7% per year. However, capital gains taxes must be paid on the profits when the investment is sold. Assuming the investor sells the investment at retirement (after 30 years), the capital gains tax will be applied to the growth, reducing the final amount.

Investing with a Roth IRA

Using a Roth IRA, the same $6,000 annual investment grows at the same average rate of 7% per year. Since Roth IRA withdrawals are tax-free in retirement (assuming the account has been open for at least 5 years and the account holder is 59 ½ or older), the investor enjoys the full amount of growth without any tax deductions.

Conclusion

Investing within retirement accounts can offer significant tax advantages over using after-tax cash, especially when considering long-term growth. By taking advantage of tax-deferred or tax-free growth, investors can significantly enhance their retirement savings. This strategic approach to investing not only helps in maximizing wealth but also in achieving financial security in retirement.

Remember, while retirement accounts offer great tax benefits, it's essential to consider your financial situation, retirement goals, and tax implications before choosing the best investment strategy for you. Consulting with a financial advisor can provide personalized advice tailored to your unique circumstances.

Let's now calculate the results for the case study to provide a clear comparison.

Based on the calculations:

• Cash Investment Growth: Before accounting for capital gains tax, the cash investment would grow to approximately $566,765. After applying the capital gains tax, the net future value drops to about $508,750.
• Roth IRA Investment Growth: The investment within a Roth IRA grows to the same amount as the cash investment before tax, approximately $566,765. However, because Roth IRA withdrawals are tax-free in retirement, the investor retains the entire amount.