All about investment

by Andy Andersohn

Don’t Neglect After Tax Savings for Retirement

We are almost all familiar with retirement savings and investment programs that are pre-tax like 401k’s, 403b’s and IRA’s. These programs give you a tax break today, since the amounts you contribute today is on a before tax basis. This means your taxable income is reduced for the year by the amount of the contribution, subject to the statutory annual limits. Income earned in these “before-tax” accounts is not taxed until normally withdrawn (after age 59 ½) and then it is taxed at the rate you are subject to in the year of withdrawal.

Retirement plans that are classified as after tax work in the opposite way of their “before-tax” brethren. They are called Roth IRA’s and are funded with money after you have paid the income tax on the income in the years that you make your contribution. This “after-tax” contribution does not help you pay fewer taxes in the year you make the contribution. However, within the account the income is compounded year after year and you pay no tax on the yearly income or when you begin the normal withdrawal at age 59 ½.

This is a significant tax benefit during your retirement. Further, there is no mandatory withdrawal beginning at age 70 ½ as with the “before-tax” plans. The “after-tax” dollars you contribute to your Roth IRA are not taxed when you make a proper withdrawal. Importantly, all the income you’ve earned in the account is not taxed when it is withdrawn. This can be a significant amount.

Let’s just look at the actual benefit in just one years “after tax” contribution. Assume at age 30 you invest $4000 (the maximum for your age in 2007, if over age 50 you can contribute $5000 in 2007 as a “catch-up” provision.) and you invest it in two above average mutual funds. Their earnings over the 35 years lets assume are 8% compounded monthly. The total in you account at age 65 would be about $65,170 or the original $4000 would have grown by $61,170. You can let it grow or just take out the earnings of about $5000 a year; the principal would stay about the same and regardless of your other income you would pay no income tax on the $5000 or whatever amount you choose to withdraw.

And remember this is only one year of contributions into your “after-tax” account. For many individuals who start early enough, and make regular contributions into their Roth IRA, the amount in their account at age 65 can be staggering. You might make a Google search for “compound interest calculator” and find an online calculator then plug in numbers consistent with your age, years to retirement, assumed return on your money and possible amount of contribution each year. So, contributing to an after tax savings account today helps reduce the amount of taxes you’ll pay during your retirement. This is to you benefit because most of us plan to live on a smaller income during our retirement years, however start early enough and you’ll have greater income when retired than when working. This greatly improves your quality of life during retirement and opens up a myriad of options during your retirement years.

For a relatively small monthly after tax contribution each during your working years, you can be accumulating a large tax free account to use during your retirement years. In the end, you won’t pay income taxes earned amount in your “after-tax” account. This is in contrast to traditional IRAs and 401ks, where you’re really just delaying the payment of taxes since you eventually will pay taxes on every bit of money in these accounts, even the income that has accrued.

Many financial experts recommend that you plan for your retirement using a combination of before tax accounts like 401ks or 403bs along with after tax savings accounts or Roth IRAs. Using this combination helps you to save for your retirement in a way that helps you avoid some taxes both today and during your retirement years. This combination is one of the best ways to save taxes now and have a financially secure future.

About the Author

Andy Andersohn is a small business owner and long time tax preparer. Learn more valuable Tax Planning Resources for business owners and individuals. Get your FREE 11 page Tax Saving Guide. At his Tax Help Plus site discover a wealth of more current tax help.