Weekly Market Update - 5/19/2023
Dow Jones Industrial 33,427 +0.4%, S&P 500 4,192 +1.6%,
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Are You Maximizing Your Retirement Accounts’ True Earnigs Potential?
The rules around retirement in the United States are consistently changing. More specifically, the rules surrounding the tax deductibility of contributions into retirement accounts are fluid and can lead to confusion about just how much individuals and couples can contribute to all their various retirement accounts.
One of the most common misconceptions regarding retirement accounts is summed up in the following sentence: “I have an active 401k account with my current employer – therefore, I can’t contribute to my IRA account.” This statement is, unfortunately, a common belief among individuals in this country. Fortunately, it is also FALSE. If you are an active participant in a 401k account, you absolutely CAN contribute to an IRA. You may not be able to take a tax deduction on your contribution (based on income restrictions), but you can still contribute to an IRA, and defer paying annual capital gains within the account and defer taxes until a future date when funds are withdrawn from the IRA.
Another common misconception regarding IRA contributions goes something like this: “If I can’t take a tax deduction for a contribution into my IRA, then it doesn’t make sense to contribute to it each year – I’d be just as well off putting the money into a regular brokerage account .” Au contraire mon frère – You can still see notable tax benefits by contributing to an IRA, even if your income prevents you from deducting these contributions. Let’s use a real-life example to show you why it DOES benefit you to contribute (even without a tax deduction) to an IRA:
Take a look at what happens when Jane, who is 50, contributes the maximum amount to her IRA and compare this to John (also 50), who puts the same amount of money in a traditional brokerage account each year. We will assume growth of 6.2% in both accounts (which is the rate of return on the S&P over the last 50 years adjusted for inflation; note that Jane can contribute $6,500 a year to her IRA + a $1,000 catch-up because she’s 50 years old; we’ll assume Jane’s earnings are above the threshold for her to deduct the IRA contributions on her annual tax return for purposes of this example. We will also assume that both Jane and John will retire at age 67).
- Jane contributes $7,500 to her Traditional IRA on Jan 1st of year 1, (not deductible on her income tax return). The contribution grows by 6.20% to $7,965 at the end of year 1.
- John invests $7,500 in a traditional brokerage account, also on Jan 1st of year 1, without any tax advantages. The investment also grows by 6.20% to $7,965. At the end of year 1, John will owe capital gains taxes (we’ll assume 20%) on the $465 gain, or $93.
- Jane contributes another $7,500 to her Traditional IRA on Jan 1st, year 2, which grows at 6.2% along with the existing balance – this brings her total balance at the end of year 2 to $16,424 (initial contribution growth + Year 1 growth).
- John adds another $7,500 to his traditional brokerage account, also resulting in a balance of $16,424. But John again will have to pay taxes on the capital gains generated in the account, which at this point are $1,424 (or taxes of ~$285).
This pattern continues until they retire at age 67.
- Jane’s Traditional IRA would have grown to $228,732, assuming the same 6.20% annual growth rate. She will have paid zero capital gains taxes earned over this 17-year period.
- John's traditional brokerage account would have also grown to approximately $228,732 due to the 6.20% annual growth rate. However, he would have paid taxes on the investment gains each year. Assuming a 20% tax rate on the investment gains, his after-tax balance would be around $208,485 (assuming taxes are paid out of the brokerage account), which is less than Alex's tax-deferred Traditional IRA balance.
Over the course of the 17-year period, even without a tax deduction for contributions, John ends up paying over $20k more in taxes in the traditional brokerage account than he would if he had contributed to a traditional IRA. It is important to note that when Jane begins to take distributions (voluntary ones or Required Minimum Distributions that are mandatory) she will pay income taxes on the amount taken out each year. However, a vast majority of Americans’ tax brackets drop substantially after they enter into their retirement years. This is one of the main advantages of tax-deferred retirement accounts: You are waiting until you hit your “non-peak” earning years to take money from your accounts to pay a smaller tax bill to the government.
Also, it is worthwhile noting that this example does NOT factor in increases in contribution amounts available for IRAs that will inevitably happen in the future. Factoid: When the IRA was created in 1974, the contribution limit per year was $1,500; it has since climbed to $6,500 for individuals in 2023 with a $1,000 “catch up” provision for those 50 and older. If we were to incorporate potential increases of future maximum contribution amounts, the positive impact of investing in a traditional IRA vs a brokerage account would be even larger.
The sooner you make sure that you’re taking advantage of ALL of the tax benefits of retirement accounts, the sooner you will get on the path to maximizing your income and future retirement nest egg. The power of compounding is amplified over time, so if you haven’t started, please reach out to your advisor here at M&R and we’ll guide you through the process.
Have a Great Weekend,