Determining Tax Rates When the Money Is Needed
The ability to defer taxation on saved income set aside for retirement until the money is actually needed, in your retirement years, is the benefit that stands out the most with people. It is only one of the benefits of retirement accounts though, but it’s one that certainly can make a real difference in how much tax you will ultimately pay on these savings.
Depending on the difference in the taxation rates when you’re working and when you retire, being able to defer the tax on your savings until you are subject to a lower rate of tax overall can be a real benefit indeed.
If you are paying a third of your income in tax presently, and you later end up paying only a quarter of it in tax, this might not seem like all that big of a difference, but if you’ve managed to save quite a bit of money, it certainly can.
If you’ve saved up a million dollars over the years for instance, this 8% less tax paid adds up to $80,000. In some cases, people might even go from paying 50% to only paying 25%, in which case the tax savings now add up to a quarter of a million dollars.
Given that it is at this later period where you will need the money, the spending of this saved money will be deferred anyway, so it’s not that you give up anything to defer the tax.
In terms of the government’s interest, who create and allow retirement accounts, they do prefer that people be better off in retirement, but that’s not the only reason why they allow for tax deferral.
The idea of progressive taxation is to tax people who are seen to have a greater ability to bear a bigger tax load at higher tax rates. When we look at the big picture though, one’s ability to bear taxation over one’s lifetime and not just year after year, it makes perfect sense and is seen as fair as well to look to smooth this capacity by taking into account both one’s working years and one’s retirement years.
This doesn’t give people saving for retirement a tax break per se, it just serves to make the amount of tax they pay fairer when their retirement years are allowed to at least be entered into the equation.
The Impact of Inflation on Deferred Tax Dollars
Even if you manage to set things up so that you don’t even have an income drop off in retirement, meaning that you’re still earning the same amount of money and will pay the same tax rate, presuming taxation rates stay constant over this time, there are still benefits of deferring the tax on income set aside for retirement.
In this case you’re probably saving quite a bit if you’re putting yourself in such a comfortable position, which means that you’re deferring a lot of tax, more so than average. Does deferring tax present its own benefits though apart from the potential tax savings from paying lower rates later?
It in fact does, and one of the ways that it benefits savers is that the value of the money paid back is less in the future due to inflation. Inflation can be counted on pretty well to continue to occur, and this means a dollar now will be worth less and perhaps considerably less years down the road.
Let’s say you contribute to your retirement account this year and defer $1000 in tax. This is money that you still owe the government, while you may end up only paying a portion of that down the road, $700 for instance instead of the $1000, there’s another way that you will pay less, even if you still pay the full $1000 from not having a drop in income.
Let’s say that ends up being the case, and your income remains constant in retirement. We’ll say that you make $50,000 a year today, and down the road when you retire, that amount increases to $100,000 to keep up with inflation.
This isn’t unrealistic and in fact, depending on how many years you have to go to retirement, this could be considerably higher.
If we look at the 40 year period from 1967 to 2017, today’s $50,000 a year was equivalent to about $6,800 a year back then. If we project this ahead 40 years, assuming the same rate of inflation, this brings us up to $367,000 being equivalent to today’s $50,000.
That $1000 you deferred in taxation now later becomes worth only $136 in the future, meaning that if your tax rate didn’t change, that’s all this debt would be worth then when looking at the value of current money today.
This is because the value of that $1000 that you didn’t pay in tax goes down, meaning that your tax liability goes down each year due to inflation, and according to the inflation rate. In essence, you are getting returns on this amount equal to the inflation rate each year that the tax is deferred on the amount.
This is a benefit that few people are aware of, but it’s a real benefit for sure, and over time, this can be an even bigger benefit than paying a lower tax rate on it. We get to enjoy both benefits though if our income goes down, as it does with most people.
The Power of Investing Your Tax Deferral
The third benefit of tax deferral is another one that most people don’t really think about, and this involves investing the tax money that you are deferring over the period of the deferral. In our example, this $1000 can be put to work and provide additional returns through investing it.
If we are averaging a certain positive return over the long term, then we’ll get this return on our savings, and we’ll also get the same rate of return on our tax deferral amount as well. Since the goal is to invest our savings anyway, this extra money that we get to use is along for the ride as well.
Depending on how well your investments do over time, and how long you are investing, this can add up to quite a bit more than the amount of tax deferred. If not for the tax deferral, we would not have access to this money to invest, because it would instead be collected by the government in tax and go into their account.
Instead, it is left in your account for now, and for now can mean several decades even. All the time it is in your account, it can be put to work for you, where it can grow in value.
While the profit that you make from this, should your investments be successful that is, is subject to taxation when you cash it in later, you always get to keep a significant portion of income earned, which the growth of tax deferral amounts is, additional income.
In addition to all this, retirement accounts serve to keep people on the right track as withdrawing from them have tax consequences, and therefore people are more likely to stick with their plan and not get sidetracked by spending the money capriciously.
While there may be times when one is required to withdraw from retirement accounts early, it only makes sense to do so when the need is great enough to offset your perhaps paying even more tax than you would have if you didn’t defer it, and there may be other penalties involved as well.
Overall, retirement accounts are great ways to save for retirement, as they are rife with benefits, and some very significant benefits as well. If you are planning on saving for retirement anyway, it only makes sense to put yourself in a better tax position while doing so.