Summary
Remember when Social Security income alone used to be enough to retire on? I bet the answer is no and obviously you’re not alone in this. Although the topic of Social Security income is a very lengthy discussion on its own, we’ll be focusing on another tool we have for providing us retirement income. We’ll begin with a treetop overview on retirement accounts because this can be a very complicated matter but we can easily talk about it all the same with this same topic.
What is a retirement account? You guessed it, it’s an account you put money in specifically for retirement. And since we’re talking about taxes we’re going to be talking about the IRS too. Hooray! What makes it a retirement account is the IRS provides tax benefits to these accounts and because of these benefits they also say you cannot withdraw these funds prior to retirement without incurring penalties. Retirement is defined by the IRS as when you reach the age of 59 1/2. I wouldn’t dwell on that number too much because you’re likely to ask, “Why not just make it 60?” My best answer is its like going on a first date and you say, “Let’s meet at 6:07pm.” It’s odd enough for you to question it so now you’ll never forget it. Moving on, you’ll pay penalties if you withdraw money from retirement accounts prior to age 59 1/2. In case you’re wondering the penalty is 10% of the account value. Additionally, you have to pay income taxes on the dollars you haven’t paid taxes on yet. There are exceptions to this as there are many things in life but again we’re sticking with high-level here. These benefits are strong enough to implement age restrictions and penalties on them so why don’t we get into what they are.
#1: Pre-Tax Contributions. With this benefit, money is deposited into a retirement account on a pre-tax basis. What that means is money goes into your account before you pay taxes on any of those dollars. No Federal taxes, State taxes, or even deductions on wages for employer benefits. 100% of your money goes into the account when you do it on a pre-tax basis. The concept is fantastic because there’s a discrepancy between what your employer pays you and what gets deposited in your bank account due to taxes. If, for example, your employer pays you $5,000 a year, you don’t receive $5,000 in your bank account. Taxes and usually other deductions are taken before it even gets to you. But, if it all goes into a retirement account via pre-tax contributions nothing is taken out of your earnings and the full amount goes into the account. So you’re saying you can get paid $5,000 a year and you get to keep all $5,000 without any taxes taken from it? Yep! Crazy concept, right? I joke a little but this is actually how it works. There are of course limits to how much you can deposit into retirement accounts and those can be found here. Clearly most need to keep at least some of their income, whatever it may be, for daily living expenses. There’s one last benefit I’ll mention in conjunction with these contributions but don’t want to harp on yet. Since you’re depositing money into an account that you’re not paying any taxes on, the IRS does not count it as earned income for you. E.g., if you earn $20,000 a year and deposit $5,000 pre-tax into a retirement account your taxable income is less that $5,000 so you only pay taxes as if you earned $15,000. Don’t get too excited because again Uncle Same always gets paid so you’ll eventually have to pay taxes on these dollars but not yet (insert closing seen from Gladiator).
#2: Tax-Deferred Growth. Now you have money inside a retirement account. What happens next? Well, you invest the money so it grows but in whichever manner you decide to invest it the big picture here with this benefit is it grows without having to pay taxes on it. You know how at the beginning of the year you get a letter from your bank saying you owe taxes on the interest you earned? Let’s be honest, we all likely haven’t seen one in a while but chances are better now with interest rates being so high. This is the same growth we’re talking about in a retirement account but the difference here is you don’t have to pay taxes on it until later. Let’s say for example you open a retirement account with $5,000 on Jan 1st and on Dec 31st its value is now $10,000. You should give yourself a high-five because you just doubled your money! Actually, make it a high-ten because you won’t be getting that tax form either saying you owe taxes on the growth where normally you would in a non-retirement account. Hence why it’s tax-deferred because you pay it later. This is another powerful concept called compounding where that growth you just earned goes back to work for you. It’s growth on growth if that makes sense.
#3: Tax-Free Withdrawals. Here’s what you may consider the best of the 3 simply because it says the words “tax-free” in it. The self-explanatory part is it allows you to withdraw your money without paying any taxes on it. To get these dollars tax-free in addition to penalty-free you need to be of that lovely, round-numbered retirement age of 59 1/2. One of the major benefits of this is it provides predictable income because you don’t have to pay taxes on it. In fact, in a literal sense, you’ve taken your money out of the tax system with this method. It doesn’t matter what tax rates change to in the future, the money you withdraw from here will be exactly the same as what goes into your bank account.
Time to add all this up. You can deposit money into a retirement account without paying taxes on it, while your money grows you don’t pay taxes, and when you withdraw your money you don’t pay taxes. All 3 of those combined equals not paying taxes at all which is fantastic however that’s sadly not an option we can choose. As you may have noticed in the summary you can only have 2 of 3 benefits in an account and they’re in specific combinations. There are only 2 options, they both include tax-deferred growth, but you must pick either pre-tax contributions or tax-free withdrawals to go along with it. Either you’re depositing money without paying taxes or you’re withdrawing without paying taxes. You can definitely have 2 separate accounts though, 1 with one option and 1 with the other. Just at some point you’re paying taxes but the question is do I pay taxes now or later? Which option makes the most sense for you will have to wait for another post.