April 15th can be a day to be dreaded for many. No one wants to pay taxes, and almost everyone is looking for ways to cut their tax liability. One of the ways many reduce their tax liability is to contribute to an IRA or their company 401(k) plan.
Is contributing to an IRA or 401(k) a good idea? Well, you get a tax break! That is the standard line a financial planner would advise during tax season. The current maximum contributions to a 401(k) plan is $17,500. If you are 50 or older, and if your 401(k) plan permits it, you can contribute an extra $5,500. The max contribution to an IRA is $5,500 ($6,500 if 50 or older).
The key question to ask, is the tax break worth it? We are led to believe that it is. Let’s look at a scenario to see if the tax break is worth it. A single, 35 year old male, earning $80,000 is in the 25% tax bracket. If he contributes $5,000 this year to save for retirement he will get a $1,250 tax deduction.
To save $1,250 is worth it right? The problem with traditional financial planning is that the here and now is looked at, and not down the road. If the same single, 35 year old male invest $5,000 this year and every year until he is 65 his money will grow to $729,753 at a 8% annual rate of return. Once he retires he can conservatively withdraw 5% annually to live on, which comes to $36,487.65 in the first year. Not factoring in social security income, or other credits and deductions, for tax purposes the income of $36,487.65 will put him in the 15% tax bracket. The tax on the $36,487.65 comes to $4,112. He will save $1,250 only to pay over three times in taxes in retirement.
This is a simple illustration to show people pay more in taxes during retirement, than they save in taxes from their contributions during their working years. The example is also based on the current tax year, and we have no idea what the future tax rates will be. The important lesson to learn here is that it is better to pay taxes on the seed, and not the harvest. Seek an investment that allows for tax free distributions during retirement. New Freedom Financial can guide you into the proper tax free retirement program.