The Power Of The Tax Deferred Account
If you asked ten people what life’s greatest expense is, there’s a good chance ten of them would say either:
· Housing (rent or mortgage),
· Education (student loans),
· Child care, or
· Car (loan payment & interest).
For the majority of us, these answers would all be wrong. Life’s greatest expense is taxes! And quite frankly, it’s not even close. Someone earning $100,000 a year, is going to be on the hook for at least $20,000 in taxes. This includes your federal income tax, state income tax, and social security tax.
That annual income related tax figure is greater than any of the expenses above. We could go even further and discuss the sales taxes, property taxes, fuel taxes, etc. that you pay throughout your lifetime, but we will stop with income related taxes. Whether you agree or disagree with the amount we pay in taxes is a topic for another newsletter but suffice to say we can all agree we pay a lot in taxes!
So, when the opportunity to reduce life’s greatest expense presents itself, there is no wonder people will (and should) take advantage of it. We have all heard of the 401(k) account (or IRA, 403(b), 457). And the majority of people I come across understand you should put money in your 401(k) plan in order to help fund your retirement (whether they do it or not). Why participating in a 401(k) plan is so powerful is lost on many… and this stems from our underestimation of the impact of taxes throughout our life.
As a tax deferred account, the answer to that why question is two-fold: 1) The 401(k) is allowed to grow without any tax implications, and 2) Your contributions are deducted from your income, lowering your income tax paid. This is extra money you can contribute to your 401(k) account. On top of that, 401(k) rules force you to stay invested for the long-term (i.e., until retirement at age 59 ½) inadvertently leaving your money alone to take advantage of compound interest/returns. I think this is called a win-win situation!
The chart to the right depicts two individuals contributing $10,000 annually, earning a 9% return over a 25-year period. The only difference is that one investor utilizes a 401(k) account, saving 20% in taxes ($2,000 annually) and investing that savings into his/her account. On the surface, the 401(k) investor contributes an extra $50,000 over the 25 years. But, due to compounding interest, the 401(k) account grows 33% more than the other account. Quite a difference for simply making the choice to use a tax deferred account.
One focus of our investment philosophy is minimizing expenses. In fact, even before we make a single investment selection, if we’ve managed to set up a client in the most efficient manner possible (i.e., selecting right accounts, minimal transactions, etc.), we are that much closer to investment success… on pace to achieve a client’s goal. Quite simply, we cannot overestimate the value of tax deferred accounts in this effort.