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Investing Unit 7: Advantages of Retirement Accounts

Last Updated: January 08, 2012

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Advantages of Retirement Accounts

A major advantage of tax-deferred investing is making contributions to a retirement account with pre-tax dollars. In many instances [e.g., 401(k) plans], the government allows taxable income to be reduced by the amount of the contribution to a tax-deferred retirement plan. As a result, you can have the same amount of money in your pocket and invest what you would have paid the government. For instance, if you are in the 25% marginal income tax bracket and you contribute $1,000 to a tax-deferred retirement plan, you would lower your federal income taxes by $250 (0.25 times $1,000). The savings is based on your marginal tax rate, i.e., the rate you pay on the highest dollar of earnings.

There are six different tax rates in 2012-- 10%, 15%, 25%, 28%, 33%, and 35%. The higher your marginal tax rate, the more you, as an investor, benefit from pretax dollar contributions and tax-deferred earnings. Figure 1 shows the 2012 tax rate schedules for your reference in determining marginal tax rates. These figures are adjusted annually for inflation.

Figure 1. 2012 Tax Rate Schedules

Single-Schedule X

Taxable Income Over But Not Over Marginal Tax Rate
$0    $8,700  10%
     8,700    35,350  15%
   35,350    85,650  25%
   85,650  178,650  28%
 178,650  388,350  33%
 388,350 ----  35%

Head of household-Schedule Z

Taxable Income Over But Not Over Marginal Tax Rate
$0  $12,400  10%
   12,400    47,350  15%
   47,350  122,300  25%
 122,300  198,050  28%
 198,050  388,350  33%
 388,350 ----  35%

Married filing jointly or Qualifying widow(er) - Schedule Y-1

Taxable Income Over But Not Over Marginal Tax Rate
$0  $17,400  10%
   17,400    70,700  15%
   70,700  142,700  25%
 142,700  217,450  28%
 217,450  388,350  33%
 388,350 ----  35%

Married filing separately - Schedule Y-2

Taxable Income Over But Not Over Marginal Tax Rate
$0    $8,700  10%
   8,700    35,350  15%
  35,350    71,350  25%
  71,350  108,725  28%
 108,725  194,175  33%
 194,175 ----  35%

 

A second advantage of tax-deferred investing is that earnings grow faster because they aren't taxed until withdrawn. Instead of paying tax on the interest earned, it continues to compound until the investment is sold. Over time, the gap between the value of a taxable and a tax-deferred account, earning the same rate of interest, increases sharply. See Figure 2 for an example.

 

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