Earned Income is the Highest Taxed Income
I’ve obviously talked about the importance of tax-deferred investing many times before in other posts https://thefinancialstoic.com/wp-admin/post.php?post=362&action=edit but it’s so important that I need to dedicate a post specifically to discuss how to take advantage of tax-deferred retirement accounts.
Let’s be honest with each other…being a W-2 employee where you work for someone else, as we’ve discussed in great detail in other posts, is simply the worse tax situation that a person can find themselves in. But if it’s any comfort to you, 93% of Americans work for someone else and are identified as being W-2 employees.
Knowing that W-2 individuals are in the worse tax situation possible, is there really anything that can be done to lessen the burden and still focus on the pursuit of wealth building? Although it’s not a massive accelerator to wealth building per se, it does cut the sting down a bit and that’s to take advantage of a tax-deferred retirement program through your employer.
An Employers Match is FREE Money
In many cases, these tax-deferred retirement programs provide us with a dual advantage. First of all, many employers provide a match to an employer based on a percentage on the employee’s income.
Although not as lucrative in some cases, my last employment engagement had my employer putting up to 6% of my salary into my retirement fund provided that I would match them dollar per dollar. Explained in another way, my employer was putting in a $1 for every $1 I put into my own retirement fund up to a maximum level of 6% of my salary for that given year.
This is effectively saying that my employer was willing to give me a 6% raise without me working for it, prior to taxation, if only I put in the same amount of money. As so many financial advisors correctly identify, to NOT take advantage of this program is literally leaving someone else’s money that they’re willing to give you on the table!
Tax Free Saving and Investing
The second benefit that is derived from participating in a tax-deferred retirement fund is that you do not pay taxes on the amount when either you or your employer puts money into the fund. Technically, you are reducing your take home pay by the amount that gets put into this fund ‘prior’ to having any income taxes paid on that money.
More specifically, if you made $1,000 a week and chose to have $100 a week put into your tax-deferred retirement fund your gross paycheck would be immediately reduced by $100 and that $100 would then be transferred into your retirement account. You would then be taxed on $900 as your gross income to get a net amount of income that would go home in a paycheck with you to cash.
This dual benefit can be substantial overtime as it limits the tax you pay on your income, the fund compounds along with your employers contribution and you presumably get to withdraw the funds and pay tax on them in retirement at a lower income (a ROTH 401(k) has different rules for taxation).
As I’m sure you figured out by now, these tax-deferred retirement accounts have names such as 403(b), 401(k) and 457.
All identified by the specific section they maintain in the American tax code. Even though each of them have their specific nuances, the overall verdict is that it is one of the only opportunities for a W-2 individual to participate in an income tax-advantaged program.
Take Advantage of Time in the Market – Not Timing the Market
Let’s use the example of a 30-year old who makes $75,000 a year and participates in her work provided 401(k) that has a 6% match. If she were to somehow be able to contribute the maximum amount on an annual basis, which is currently $19,000 a year, she would be able to have this complete amount invested prior to taxes. Assuming she works and contributes the same exact each amount for the next 35 years, she would have invested personally, excluding her employers contribution, $665,000 to her retirement account.
Not having had to pay taxes on her retirement contribution, she would have avoided paying $146,300 in taxes on her contributions over those 35 years (assuming a 22% income tax bracket). Instead, that $146,300 was working for her conceivably making 7% annual returns and being compounded upon itself.
The Impact of Saving the Maximum Amount
In fact, using an investment calculator and doing some basic math that $146,000 of funds ($19,000 x .22 = $4,180 x 35 years = $146,300) which would have otherwise been gobbled up to pay income taxes, could grow to potentially over $662,000 dollars!
It is CRAZY to believe that what just otherwise would have been LOST in paying income taxes could beneficially lead to a GAIN of around $662,000 if it would have been invested into a 401(k) program.
Let’s go back and look at what the full $19,000 annually would be able to contribute to our example person’s retirement fund.
If we look at what her complete contribution over 35 years would be ($19,000 x 35 years – $665,000) using a 7% annual rate of return over that time our person could accumulate approximately $3 million dollars!
Again, this is CRAZY! Not having to have ‘beat the market’. Not having to have been an ‘expert stock picker’. Not even having to have any expertise in the world of equities, just the foresight and commitment to set aside $19,000 each and every year and our example person could presumably have around $3 million in retirement funds!
Piling On – Your Employer’s Match
One more thing to pile on. Let’s look at what the additional employer’s contribution would do to our sample person’s retirement account if we included that amount along with her $19,000 annual contribution.
This would result in adding the employers 6% match ($75,000 x .06 = $4,500) $4,500 annually to her $19,000 for a total of $23,500 being invested annually prior to taxation. Presuming a 7% annual rate of return over 35 years and our person would have closer to $3.7 million in her retirement account at the end of her working life.
I think it’s pretty obvious. W-2 individuals have a very simple choice. They can take the entire amount of funds they make on a weekly basis from their jobs home with them, pay what is undoubtedly the highest tax rates (income taxes), forgo any investment compounding AND lose out on getting free money from their employer…OR…they can shelter funds from taxation on the front end, receive compounded annual returns AND receive free funds from their employer.
Could it be any more of a simple decision?
